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24–910 PDF 2005

S. HRG. 108–880

EXAMNATION OF THE CURRENT CONDITION OF

THE BANKING AND CREDIT UNION INDUSTRIES

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

ON

IMPROVED RISK-MANAGEMENT PRACTICES OF BANKS, THE CURRENT

STATUS AND DIRECTION OF REGULATORY EFFORTS TO REVISE CAPITAL STANDARDS FOR INTERNATIONALLY ACTIVE BANKS, DEPOSIT

INSURANCE, AND CONSOLIDATION WITHIN THE DOMESTIC BANKING

INDUSTRY

APRIL 20, 2004

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

LINCOLN D. CHAFEE, Rhode Island

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

MARK F. OESTERLE, Counsel

MARTIN J. GRUENBERG, Democratic Senior Counsel

AARON D. KLEIN, Democratic Economist

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

TUESDAY, APRIL 20, 2004

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Allard ................................................................................................... 2

Prepared statement ................................................................................... 47

Senator Bunning ............................................................................................... 2

Prepared statement ................................................................................... 47

Senator Crapo ................................................................................................... 2

Prepared statement ................................................................................... 47

Senator Johnson ............................................................................................... 3

Senator Reed ..................................................................................................... 18

Senator Sarbanes .............................................................................................. 23

Senator Carper ................................................................................................. 25

Senator Corzine ................................................................................................ 28

Senator Schumer .............................................................................................. 30

WITNESSES

Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC ........................................................................................... 4

Prepared statement .......................................................................................... 48

Response to a written question of Senator Santorum ................................... 103

John D. Hawke, Jr., Comptroller of the Currency, U.S. Department of the

Treasury ................................................................................................................ 7

Prepared statement .......................................................................................... 54

Response to written questions of Senator Schumer ...................................... 104

Donald E. Powell, Chairman, Federal Deposit Insurance Corporation ............... 8

Prepared statement .......................................................................................... 65

Resposne to written questions of Senator Bennett ........................................ 114

James E. Gilleran, Director, Office of Thrift Supervision .................................... 11

Prepared statement .......................................................................................... 72

Dennis Dollar, Chairman, National Credit Union Administration ..................... 11

Prepared statement .......................................................................................... 82

Kevin P. Lavender, Commissioner, Tennessee Department of Financial

Institutions, on Behalf of the Conference of State Bank Supervisors ............. 13

Prepared statement .......................................................................................... 98

(III)

(1)

EXAMINATION OF

THE CURRENT CONDITION OF THE

BANKING AND CREDIT UNION INDUSTRIES

TUESDAY, APRIL 20, 2004

U.S. SENATE,

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 2:34 p.m., in room SD–538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the

Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

I want to thank our witnesses for being here today. The purpose

of this hearing is to examine the current state of the banking and

credit union industries. This, I recognize, involves consideration of

numerous other issues. I think this is a particularly worthwhile endeavor for this Committee, though, because of the tremendous significance of so many of the matters facing the industry.

On the broadest level, the performance of the banking system is

critical to the function of the overall economy. So critical, in fact,

that Congress created a backstop for the system that potentially

gives it direct access to the wallet of the American taxpayer.

On a more basic level, the system provides consumers credit and

other financial services.

There are also issues associated with the banking system which

go beyond economic matters. As the principal means for movement

of financial resources throughout the world, the system is something that terrorists would readily exploit to further their murderous endeavors.

Furthermore, while examining these issues in relation to the system, we must keep in mind that it is not comprised of a simple,

monolithic entity. Rather, the ‘‘banking system’’ is made up of thousands of different firms of various sizes with different regulators,

which are vigorously competing in extremely complex and dynamic

national and international markets.

Thus, in light of the significant macro and microeconomic and

national security issues associated with the performance of the

banking system, I think that it is important for the Committee to

address some basic questions.

For example, how healthy is the banking system today?

What are the present risks that could compromise the performance of the system?

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What future risks are looming on the horizon?

What can be done to strengthen the system against these risks?

I have long supported ongoing review of the regulatory structure

governing the banking system. I think it is important to closely

monitor these laws and rules because, due to the fast-paced nature

of changes in the financial service industry, they can readily outlive their intended purposes and become inefficient and very burdensome.

In the past, I have worked directly on regulatory relief legislation. I am happy to note that Senator Crapo has taken up this effort on this Committee and is working on his own regulatory relief

measure. I commend him for this. I look forward to working with

Senator Crapo and others and hope that today’s hearing will prove

helpful to their efforts.

Before moving on, I want to recognize the contributions of Chairman Dollar, who will soon be leaving his post at the National Credit Union Administration. Good luck in your future endeavors. And

I thank all of you for being here today.

STATEMENT OF SENATOR WAYNE ALLARD

Senator ALLARD. Thank you, Mr. Chairman. I really do not have

any opening statement. I do have a short one I will just put in the

record because I am anxious to hear from the panel.

Chairman SHELBY. It will be made part of the record, without objection.

Senator ALLARD. I would just like to thank all of you for taking

the time to testify before our Committee and I look forward to what

you have to say.

Chairman SHELBY. Senator Bunning.

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. I just would like permission to put my statement in the record.

Chairman SHELBY. Without objection, your complete statement

will be made part of the record in its entirety.

Chairman SHELBY. Senator Crapo.

STATEMENT OF SENATOR MIKE CRAPO

Senator CRAPO. I will make my statement a part of the record

as well, Mr. Chairman. I look forward to working on reg relief and

the other critical issues before us today. Thank you.

Chairman SHELBY. Senator Crapo, I do not know if you were

here a minute ago. I did acknowledge your work in the regulatory

relief area because as we all know and as you especially know,

there are a lot of laws and regulations that have no meaning in today’s financial world, except to add a burden of cost to people.

Senator CRAPO. You are correct, Mr. Chairman, and I did have

a statement on that. I am not going to give it all because I have

questions for the panel, and I would like to get into those. But I

appreciate the Chairman’s recognition of that and the Chairman’s

willingness to work with me on developing that legislation.

Chairman SHELBY. Absolutely.

Senator Johnson.

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STATEMENT OF SENATOR TIM JOHNSON

Senator JOHNSON. Well, thank you, Mr. Chairman, and I will be

brief because we do need to move on to the panel. And I welcome

all of them to this hearing.

I want to thank you and Ranking Member Sarbanes for holding

this hearing. My constituents in South Dakota are extremely fortunate to benefit from a stable mix of large and small financial institutions. We have more than 100 small banks and credit unions

scattered throughout the State, reaching into the most remote of

our communities. These small banks and credit unions provide critical financial services to these communities which might otherwise

be underserved. And as I have noted in the past, deposit insurance

is a critical component to the financial services provided in those

communities.

I remain hopeful that this Committee will work together over the

next few remaining months to pass once and for all comprehensive

deposit insurance reform to ensure the continued health of the system. With the number of legislative days waning, we are up

against the clock. At this point the major hurdle appears to be getting the Administration and others to look at the facts behind the

need for increased retirement coverage. I strongly believe that the

retirement coverage issue deserves distinct analysis, and that is

why in November 2001, I held a Subcommittee hearing on that

topic alone. Health care costs are exploding, corporations are taking away benefits from retirees in too many instances, and it is no

longer absurd to suggest a person might need more than $100,000

to make it from age 65 through the remainder of their life.

We have agreement, just about everyone, on all the other components of our proposed legislation, and we have a strong bipartisan

team committed to reform, including Senators Hagel, Reed, Enzi,

Stabenow, and Allard. The time to adopt comprehensive deposit insurance reform is now, and I expect we will hear today that the

FDIC and NCUA funds and the banking and credit system as a

whole seem to be doing quite well. The last thing we want to do

is wait to legislate during a crisis, and this issue first gained traction because of concern over the declining insurance fund ratios,

particularly in the Bank Insurance Fund. I do not think anyone is

sorry to see these ratios rise since the whole point of this discussion is the safety and soundness of America’s financial system.

In addition, nothing changes the fact that new entrants into the

marketplace, large security firms that have recently chosen to

sweep large deposits into insured accounts, continue to receive deposit insurance for free. The uptick in ratios is simply no excuse

for Congressional inaction in the face of what everyone agrees is

a system that needs revision.

Coming from a rural State, I know firsthand how bleak the situation would be if community banks and credit unions did not provide the first-rate services that they do. We need to make sure that

Congress does not turn a blind eye to marketplace distortions that

allow enormous corporate entities to manipulate the system to

their advantage, and the banking industry continues to generate

record profits year after year. Capital levels have remained steady,

problem institution levels remain at historic lows, and the deposit

insurance fund ratios are growing.

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During this period of stability in the system, our financial institution regulators have had the opportunity to focus on the future,

and we here in the Committee need to do the same.

I look forward to listening to the panel testimony today, and I

thank the panel members for joining us.

Chairman SHELBY. Thank you, Senator Johnson. I just want to

briefly respond to your request.

A lot of us are interested in deposit insurance reform. I am particularly interested in about four or five items there, but I do not

think reform is necessarily reaching back and running the insurance rate up. And others, I think, tend to agree with me on that.

I do not know if it is a majority, but I would be glad to sit down

with you and work and see if we could look at something prospectively in the future.

Senator JOHNSON. Thank you, Mr. Chairman.

Chairman SHELBY. I know you have worked hard in this area.

We are honored to have again before the Committee a distinguished panel: Alan Greenspan, who really needs no introduction,

Chairman of the Board of Governors of the Federal Reserve System; John D. Hawke, Jr., Comptroller of the Currency; Donald E.

Powell, Chairman of the Federal Deposit Insurance Corporation;

James E. Gilleran, Director, Office of Thrift Supervision; Dennis

Dollar, Chairman of the National Credit Union Administration;

and Kevin Lavender, the Tennessee State Bank Commissioner,

Tennessee Department of Financial Institutions, testifying on behalf of the Conference of State Bank Supervisors.

Gentlemen, we welcome all of you here. Your written testimony

will be made part of the record in its entirety and be part of the

hearing process.

We will start with Chairman Greenspan because I think people

would like to hear from you and have a chance to question you.

Chairman Greenspan.

STATEMENT OF ALAN GREENSPAN, CHAIRMAN

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Chairman GREENSPAN. Thank you very much, Mr. Chairman.

Chairman Shelby, Members of the Committee, I am pleased to be

here this afternoon to discuss the condition of the U.S. banking system and related matters.

Three years ago, bank asset quality, mainly in the corporate sector, began to decline, but banks were well positioned to deal with

emerging problems. Their capital position was strong, the industry’s overall asset quality was high, and banks had made significant progress in diversifying their sources of revenue.

As the economy slowed, the industry was quick to act in addressing its emerging asset problems. Household credit demand stayed

high and earnings remained at or near record levels, while assets

continued to expand.

Importantly, the recession was mild and short-lived, making the

necessary adjustments easier. Strong capital positions and a mild

recession were probably the most important factors, but the benefits of an ongoing effort by banks to improve risk measurement and

management and the maturing of new techniques for shifting risk

should not be ignored.

5

The basic thrust of recent efforts to improve the management of

risk has been better quantification and the creation of a formal and

more disciplined process for recognizing, pricing, and managing

risks of all types. Earlier detection of deviations from expectations

now can, and does, lead to earlier corrective actions by bank managers and, as necessary, by bank supervisors as well.

Better methods for measuring credit risk also have spurred

growth in secondary markets for weak or problem assets which

have provided banks with a stronger basis for valuing these credits

and an outlet for selling them and limiting future losses.

The result is greater liquidity for this segment of bank loan portfolios and the earlier transfer of weakened credit from bank balance sheets. Portfolio risks also have been increasingly hedged by

transactions that do not require asset sales, such as derivatives

that transfer credit risk.

Recent initiatives of the Basel Committee on Banking Supervision to revise international capital standards have helped focus

attention on risk measurement practices and have encouraged further investment in this area. In my view, such efforts are crucial

to extending the progress that the industry has already made. We

need a more accurate, more risk-sensitive measure of capital adequacy to provide our large, complex banking institutions with appropriate risk management incentives and to provide the regulators with a more reliable basis for supervising them in a way that

focuses on true risks. In the process, such a measure should also

enhance our efforts in taking prompt corrective action.

For all these reasons, I believe the U.S. banking agencies must

remain committed to the process of developing and applying a revised regulatory capital standard and a new capital accord, Basel

II, for the world’s international banks.

In reflection of public comments on last summer’s advanced notice of public rulemaking on such a revision to the U.S. capital

rules, the agencies have been successful in extending the negotiation period at Basel and incorporating into the proposal significant

revisions as described in my statement.

There are still some important details to be worked out among

the U.S. agencies, mainly on the capital treatment of credit cards.

The Federal Reserve for its part will continue to make every effort

to reach a consensus on this issue that is both risk-sensitive and

workable. If successful, a new Basel proposal then could be published on schedule at mid-year that could be tested among larger

U.S. banks later this year and could be the basis for a good-faith

notice of proposed rulemaking next year.

Our basic goal, shared with all the other agencies, is to develop

a revised accord that reflects 21st century realities, that meets our

needs for a safe, sound, and competitive banking system, and that

addresses the legitimate concerns of the industry. Among the legitimate concerns of some banks that must be addressed is ensuring

that the application of Basel II in the United States to only our

largest banks does not upset the domestic competitive equilibrium.

As explained in my statement, we are carefully studying this issue

and have, in fact, uncovered some potential problems between large

banks that choose not to adopt Basel II in this country and those

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that are required to do so or opt in. We are studying other markets

to see if there are similar problems.

We will not go forward on Basel II until policies are adopted that

mitigate such effects, where appropriate. We cannot, however, respond to unsubstantiated and generalized fears of change. Such

concerns should not halt the evolution of regulatory capital standards for large, complex banking organizations that play such an

important role in domestic and global financial markets.

The significant bank consolidation that began 20 years ago reflects technological, global, and statutory and regulatory changes

and has resumed in recent months after a period of relative inactivity. This ongoing consolidation of the U.S. banking system has

not, in my judgment, harmed the overall competitiveness of our

banking and financial markets. Although they have facilitated and

fostered consolidation, the reduced legal barriers to entry—such as

the relaxation of interstate banking laws, along with technological

advances such as the use of ATM’s and electronic banking—have

provided net competitive benefits to American consumers of financial services.

Developments such as these have stimulated competition among

depository institutions and between depositories and nonbank providers of financial services. Moreover, it is worth emphasizing that

measures of concentration in local markets, both urban and rural,

have declined modestly since the mid-1990’s as most mergers are

for the purpose of expanding into new markets. Importantly, it is

in local markets where most households and small and mediumsized businesses, those customers that may have the fewest alternatives for acquiring financial services, obtain the vast majority of

their banking services.

Briefly, Mr. Chairman, let me say in answer to the question in

your invitation letter that the Federal Reserve still supports the

merger of the deposit insurance funds, enhanced flexibility in setting deposit insurance premiums, and especially wider latitude for

risk-based pricing. However, we still do not support higher deposit

insurance coverage limits.

Finally, I want to reiterate that the past decade is one in which

the banking industry has recorded persistent record profits while

providing an ever wider range of products and services to much

more diverse groups. The industry’s experience during the past several years in dealing with clear weakness in key economic sectors

reinforces the importance of strong capital positions and robust

risk management practices. Bank supervisors worldwide are working to encourage both through more accurate and more effective

regulatory capital standards based on even better internal risk

management procedures.

Thank you very much, Mr. Chairman. I look forward to your

questions.

Chairman SHELBY. Thank you, Chairman Greenspan.

Mr. Hawke.

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STATEMENT OF JOHN D. HAWKE, JR.

COMPTROLLER OF THE CURRENCY

U.S DEPARTMENT OF THE TREASURY

Comptroller HAWKE. Chairman Shelby and Members of the Committee, I appreciate this opportunity to review the condition of the

national banking system. I would like to make two key points in

my oral testimony this afternoon.

First, by virtually every measure, the national banking system,

which consists today of about 2,100 financial institutions, is in excellent health. Earnings have been at historically high levels for a

decade. In 2003, national banks set records for both return on equity and return on assets. Loan growth has also been strong overall. In 2002 and 2003, total loans grew by 7.8 and 7.6 percent, respectively.

The rise in bank assets has been fueled by the growth in bank

deposits that one might expect to see in a low interest rate environment. Deposits in national banks grew at an average 7.4 percent

over the past 3 years. But asset growth has not come at the expense of asset quality. The noncurrent loan ratio for national banks

in the second quarter of 2002 was 1.6 percent. At a comparable

point in the last economic cycle, it was 4.4 percent.

Data on failures and new entrants similarly reflects the banking

system’s health and dynamism. In 2003, only two commercial

banks failed—one national and one State-chartered institution. By

contrast, 100 commercial banks, including 33 national banks and

67 State banks, failed in 1992—the first year of recovery after the

1991 recession. Last year also saw 111 new commercial bank entrants.

By historical standards, the system is also exceedingly well capitalized. Today, all national banks, with minor exceptions, have

risk-based capital above 8 percent, and less than 1 percent of national banks have risk-based capital below 10 percent.

Concerns have been expressed about declining demand for consumer loans and loans backed by commercial and residential real

estate in a rising interest rate environment, as well as the impact

of such a development on bank earnings, to which they have made

such an important contribution. And, as recent events have taught

us, operational, strategic, and reputational risks posed by bank activities can have just as serious an impact on bank soundness as

changes in a bank’s financial condition.

Yet I am optimistic about the ability of the banking system to

overcome these challenges, just as it overcame the challenges of the

recent recession. Our optimism is based on two factors. The first

is the dramatic improvement in the tools, techniques, and processes

available to financial institutions to manage just such risks. Banks

increasingly look at risk in more comprehensive terms rather than

on a transaction-by-transaction basis.

Risk management has also benefited from the use of tools that

enable banks to better adjust and manage their risk profiles. The

growth of the syndicated loan market has enabled banks to more

broadly distribute credit exposures within the banking system, as

well as to foreign banking organizations and nonbanks. The expanding asset securitization market has provided banks with a way

of managing concentration risk and diversifying funding sources.

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And growth in the derivatives markets has given banks additional

tools to manage their credit and interest rate risk exposure.

OCC supervision provides the national banking system with a

second layer of protection against the challenges posed by our

changing economy and provides a second reason for optimism. Our

risk-based approach involves supervisory policies and processes

that tailor OCC oversight to the key characteristics of each bank,

including asset size, products offered, markets in which the bank

competes, and the board’s and management’s appetite for risk.

In response to the growing importance of nonfinancial risks, we

have strengthened our supervision in the critical areas of audit and

corporate governance. New supervisory guidance, developed both in

conjunction with other the U.S. banking agencies and independently by the OCC for national banks, set forth our expectations

that well-planned, properly structured, and independent auditing

programs are essential to effective risk management and internal

control systems.

Finally, I would like to comment briefly on developments relating

to the Basel II process. This is an enormously complex and important project in which the OCC has been deeply involved for more

than 5 years, together with our sister regulators. Even so, some important substantive issues have not yet been resolved, and we continue to work hard on those issues.

The important thing to understand is that the Basel process is

far from over. Before we adopt final implementing regulations for

national banks, a number of important domestic processes will

need to be completed. We will need first a new quantitative impact

study to provide good and reliable estimates of what the actual impact of Basel II will be on the capital of our banks. The economic

impact analysis required by executive order will also give us a better idea of the implications of Basel II for our economy. And, of

course, we will need to continue the dialogue with this Committee

and its House counterpart on the progress of the process.

Only when all of these steps have been completed will we be in

a position to draft and then put out for comment our final implementing regulations. Clearly, it will be a major, if not impossible,

challenge to get this done in time to meet the current implementing date of year-end 2006.

In conclusion, Mr. Chairman, the national banking system is

sound, and its recent performance has been strong. It successfully

weathered the recent recession and is responding in dynamic fashion to the changes in the financial services marketplace. The OCC,

too, is keenly focused on keeping pace with change and improving

our approach to supervision. We look forward to working productively with you, with Members of this Committee, and with State

officials as we pursue our efforts to achieve that goal. Thank you.

Chairman SHELBY. Mr. Powell.

STATEMENT OF DONALD E. POWELL

CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION

Chairman POWELL. Thank you, Mr. Chairman, for the opportunity to present the views of the FDIC.

FDIC-insured institutions are as healthy and sound as they have

ever been. Improvements in underwriting and risk management

9

practices helped to limit the effect of credit losses on industry earnings during and after the recession. Meanwhile, strong growth in

mortgage loans, a steep yield curve, new sources of fee income, and

cost containment efforts helped boost the net operating income of

the industry. Record earnings 2 years in a row, record returns on

assets, and a strong capital foundation are all indicators that

banks not only weathered the recent economic downturn, but also

have been a source of significant strength for the economy and for

the American consumer.

This strength is mirrored in the strength of the FDIC insurance

funds. At year-end 2003, the combined funds stood at 1.33 percent

of estimated insured deposits, eight basis points higher than the

statutory target of 1.25. While several factors, outlined in my submitted testimony, may bring this number down a bit, the fund will

likely remain strong for the foreseeable future.

As you are aware, my concerns about the deposit insurance system relate to the way it is structured. We cannot price deposit insurance based upon risk. We cannot manage the fund size relative

to our exposure. And we maintain two funds even though the historic rationale for doing so has gone away.

There is broad agreement on the key elements of the deposit insurance reform package, and the FDIC remains willing to work

with this Committee to achieve reform as soon as possible.

While the industry is strong and the outlook is favorable, we

should not overlook the potential risks in the system. Furthermore,

we should be aware of several fundamental trends in the industry

that will bring significant consequences for bankers, regulators,

and policymakers.

One area of general concern involves household balance sheets.

While households have been an engine for growth, they also have

accumulated debt to a historical high of 112 percent of disposable,

personal income. Further, households took out $1.4 trillion of new

mortgage debt since the end of 2001. Escalating household debt

raises questions about the sustainability of consumer spending and

the ability of borrowers to meet obligations when interest rates

rise. Our concerns are tempered, however, by the strength of the

household assets and the strengthening job and wage data we have

seen in recent months.

Second, vacancy rates for office, retail, and warehouse space are

near historic highs, yet commercial real estate concentration in

banks are high and increasing. We have not seen any significant

deterioration in loan performance thus far, but higher interest

rates could yield problems in some areas of the country, and we are

implementing enhanced procedures to monitor and better understand this area of the economy.

Third, it is important to recognize the volatile nature of financial

markets and the potential for disturbance to spread throughout the

system. In today’s interconnected financial system, problems that

initially appeared to be localized could lead to a more widespread

loss of confidence with a resulting impact on liquidity throughout

the system. This issue bears watching to ensure that financial market disruptions do not produce significant banking problems going

forward.

10

I am gratified that the banking industry is facing these risks

with a strong foundation of capital. The industry’s capital base has

led it to a position of unparalleled strength and competitiveness in

the worldwide banking marketplace. It is the best hedge against

the unexpected and the unknowable. We must ensure, as we move

forward with Basel II and other important initiatives, that we do

not erode this base or the regulatory framework it is built upon.

In addition to these specific issues, the FDIC is working hard to

understand the long-term trends that are driving the industry and

looking ahead to the policy questions that may arise. While the

rate of decline in the number of banks and thrifts has been slowing

in recent years, the pattern of industry consolidation is leading to

a greater divide between large and small bank organizations and

is likely to create pressures on the existing regulatory structure

and existing regulatory barriers. It also has the potential to pose

unique challenges for the FDIC.

Community banks, while numerous, represent a relatively small

exposure to the deposit insurance funds, and it would take a major

crisis among small banks to do serious harm to the funds. On the

other hand, there are a few large institutions that represent an increasingly significant share of the FDIC’s exposure.

A continuing challenge is how best to protect the stability of the

system as customers’ choices continue to expand and bank deposits

become less important in the overall financial system. Federal deposit insurance works very well for traditional community banks.

For the largest banking organizations, as they increasingly engage

in diverse, nontraditional activities, it makes sense to consider

whether different safety-net arrangements would be more suitable

for this segment of the industry. Since some aspects of our regulatory system already are tailored to recognize the differences between large and small institutions, we should consider the explicit

creation of a two-tiered safety-net that better addresses these differences.

In addition to potentially broad implications for the safety-net arrangements, the large/small divide in the banking industry will

pose other interesting questions for policymakers. For example, the

FDIC could look more to market instruments like reinsurance contracts, or catastrophe bonds to help us assess our large-bank exposure. We also should ensure that regulatory burden does not weigh

too heavily on community banks and stifle the innovation and consumer choice that are hallmarks of our system.

Finally, as this banking transformation matures, we will see the

remaining regulatory barriers come under pressure. Issues such as

the 10-percent deposit cap and the remaining barriers between

banking and commerce will need to be addressed. As the market

pressure in this area intensifies, I believe policymakers will need

to find ways to accommodate consumer demands while constructing

arrangements that address these issues. We hope that, as this

Committee and others deal with these important issues, we can be

a resource to you. Thank you, Mr. Chairman.

Chairman SHELBY. Thank you.

Mr. Gilleran.

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STATEMENT OF JAMES E. GILLERAN

DIRECTOR, OFFICE OF THRIFT SUPERVISION

Director GILLERAN. Thank you, Mr. Chairman. It is a pleasure

to be with you today. I am happy to report that the thrift industry

has come off the last 3 years in the finest shape it has ever been,

and we have reached a situation where we are at an all-time high

in the dollars worth of assets in the system and the system is at

its best profitability level that it has ever been at. Loan loss reserves are well adequate to cover all expected losses. Capital is the

highest that it has ever been. And even though we as regulators

focus on all of the risk factors already mentioned about the credit

quality and the interest rate risk and the compliance risk, et

cetera, none of these risks right now looks like it will be overwhelming to the system, at least in the near future, as far as we

can see. In fact, we believe that when we total up the first-quarter

results for 2004, they again will be a very strong quarter for the

thrift industry, even though the refinancings dropped substantially,

that the increase in homeownership in America and the continual

support of the homeownership area by the public, it looks like it

is going to be another good year.

I agree with Chairman Greenspan that we, too, support going

forward with the Basel II Accord. We look forward to the test that

has to be made in the future to determine whether or not it is a

reliable system to be able to regulate the banking system. At the

OTS, however, we believe that we as regulators should be allocating additional resources to see whether or not we can take some

of the concepts that have been devised in Basel II and see if we

can make Basel I more risk-sensitive for those other 9,000 banks

in the system that Basel II will not be touching.

Mr. Chairman, there are some things that we would like to have

changed. We would continue to like to have parity with the national banks in terms of selling investment products, and to this

date we have not been able to receive the same exemption from the

SEC that the national banks have. This is creating a competitive

disadvantage for our thrifts. So we would like to have the Committee address that going forward.

Thank you very much, sir. Glad to be with you.

Chairman SHELBY. Thank you, Mr. Gilleran.

Mr. Dollar.

STATEMENT OF DENNIS DOLLAR

CHAIRMAN, NATIONAL CREDIT UNION ADMINISTRATION

Mr. DOLLAR. Chairman Shelby, Ranking Member Sarbanes, and

Members of the Committee, I want to thank you for the invitation

to testify before you today on behalf of the National Credit Union

Administration regarding the condition of the credit union industry

in America and the National Credit Union Share Insurance Fund

that insures the deposits of credit union members nationwide.

I am pleased to report to the Committee that the state of the

credit union industry remains strong and healthy, with all indicators clearly portraying a safe and sound industry, serving over 82

million Americans and well-positioned for continued strength and

vitality in our Nation’s financial marketplace, both now and in the

future.

12

At this point I would like to just provide a brief discussion of a

couple of key ratios and trends that have been compiled from call

report data submitted by Federal credit unions to NCUA as of December 31, 2003.

The average net worth-to-asset ratio of all federally insured credit unions remains extremely strong at 10.72 percent, even though

there has been a significant share growth of over 15 percent in

2001, almost 11 percent in 2002, and just over 9 percent in 2003.

Such a strong share deposit growth would normally bring about a

significant decrease in the net worth ratio were not the credit

unions managing these increased shares effectively and continuing

to build net worth.

For example, over the course of 2003, credit union net worth,

which we need to recognize is built solely from the retained earnings of credit unions—credit unions cannot issue stock, cannot

issue subordinated debt—has increased in total dollars by 9.6 percent. This growth in actual dollars of net worth results in the highest level in history of total industry net worth, currently at $65.4

billion as of December 31.

Return on average assets is 0.99 percent, which, even with a historically high growth in shares during a low interest rate environment, compares very favorably with the recent historical trends.

Loan volume increased by 9.75 percent in 2003, but yet the credit

unions’ overall delinquency ratio remains steady at 0.77 percent

and is lower than the ratios recorded in the previous 2 years.

Savings grew to $528 billion in 2003, an increase of over 9 percent. Total assets grew to an all-time high of $610 billion, again,

an increase of over 9 percent.

Member business lending in credit unions increased $8.9 billion,

and although this category of credit union lending has increased

over the past years, member business lending still represents only

2.3 percent of all loans in federally insured credit unions.

First mortgage real estate loans grew over 16 percent to $117.5

billion, thus credit unions continue as a source of access to the

American Dream of homeownership for millions of their members.

New auto lending increased over 5 percent; used auto lending, indicating the economic times that we are in, increased by a higher

percent, 12.5 percent.

These ratios and trends, of course, taken as a whole I think are

indeed indicative of a healthy and robust industry.

We are closely monitoring a number of emerging key issues and

some of the same ones that my colleagues have mentioned here

today—challenges specifically affecting the credit union industry,

some of them; others are those related to the overall financial marketplace: interest rate risk and net margin compression; increased

competition for consumer lending; information systems and technology risk. These are all items that I discuss more in depth in my

written testimony.

I would like to briefly address, before I conclude, the condition

of the National Credit Union Share Insurance Fund, which provides Federal share insurance, coverage on credit union accounts

generally up to $100,000 per member in a single, federally insured

credit union.

13

As of December 31, there were $479 billion in insured funds,

with a 1.29-percent equity ratio at the end of the first quarter of

2004. Earnings have been sufficient to keep the fund well capitalized well into the future. But dividends to insured credit unions,

that are allowed by statute when the fund equity level exceeds the

established operating level are not likely to return, nor have they

been able to be paid over the last several years. They are not likely

to return at least until interest rates rise sufficiently to allow earnings to return to the historical levels of the previous 6 years in

which a dividend was paid.

Losses are anticipated to remain low, and extraordinary losses

are certainly not anticipated. Based upon our ongoing examination

and supervision program, we feel that credit unions are indeed positioned to have all-time record lows in losses.

As of December 31, there were 217 problem credit unions out of

a total of right about 10,000.

Chairman SHELBY. What were the sizes of those credit unions?

Mr. DOLLAR. The overwhelming majority of them, Senator, are

smaller credit unions, with risk to the fund very minimal. We, of

course, take seriously the status of small credit unions as well as

large ones, but the overwhelming majority are small.

Chairman SHELBY. Would you close those troubled ones?

Mr. DOLLAR. There are 217 of them that are coded CAMEL 4 or

5. We are watching those very closely. Where the market will lead,

or whether our prompt corrective action will be required, will be

taken—we would love to bring those credit unions back, Senator.

But some of them will not make it, and that is a part of the difficult part of our job. But that is our job, nonetheless.

In 2003, we were called upon to liquidate, merge, or arrange a

purchase and assumption for 13 federally insured credit unions.

And this number is trending lower than in the past 10 years when

we were averaging about 27 to 28 credit union mergers, liquidations, purchases, and assumption per year. So although there are

ongoing losses, it is trending downward.

In closing, let me just, without going into the in-depth detail that

I did in my written testimony, refer you to a number of our agency

initiatives that we think the Committee will find of interest, as

well as our position in response to your earlier letter for regulatory

relief suggestions. We made seven specific regulatory relief suggestions that we hope the Committee will give consideration to, and,

again, thank you for the opportunity to testify today. And I look

forward to answering any questions and serving as a resource for

the Committee.

Chairman SHELBY. Thank you, Mr. Dollar.

Mr. Lavender.

STATEMENT OF KEVIN P. LAVENDER

COMMISSIONER, TENNESSEE DEPARTMENT OF

FINANCIAL INSTITUTIONS, ON BEHALF OF

THE CONFERENCE OF STATE BANK SUPERVISORS

Mr. LAVENDER. Thank you very much, Chairman Shelby, Members of the Committee. My name is Kevin Lavender. I am the Commissioner of Financial Institutions for the State of Tennessee, and

I am also the Chair of the Regulatory Committee for the ConVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 24910.TXT SBANK4 PsN: SBANK4
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ference of State Bank Supervisors, better known as CSBS. Again,

I thank you for giving CSBS the opportunity today to testify on the

condition of the State banking system.

As you have heard from my colleagues, the general health of the

banking industry is excellent. State-chartered banks, which make

up approximately three-quarters of the Nation’s commercial banks,

have shared in the industry’s record levels of prosperity. Net income of State-chartered commercial and savings banks at year-end

2003 reached $44.2 billion, which is an 18-percent increase over the

previous year’s record levels. State banks’ aggregate equity capital

ratio stands above 9 percent. This level exceeds the industry aggregate and regulatory requirements and has risen steadily over the

past 3 years. State banks’ ratio of nonperforming assets to assets

continues to decline and stands even lower than the industry’s

overall level.

Even some areas of concern have shown improvement in recent

quarters. We saw deposits in State-chartered banks grow for the

last 2 consecutive years. Our banks are still finding good loans to

make, and we saw strong growth in earning assets in 2003.

We never forget, however, that these record levels of prosperity

are occurring in an environment of historically low interest rates.

Our examiners are paying special attention to our banks’ vulnerability due to interest rate changes. My colleagues and I have also

been particularly concerns about banks’ internal control systems

because experience has shown us that nothing disguises bad management as well as a good economy.

As you have also heard, consolidation of the banking industry

continues, raising our concerns about concentration of risk and the

range of meaningful choices available to consumers. The Nation’s

50 largest banks now hold almost 90 percent of banking assets nationwide. In Tennessee, the six largest banks hold more than 50

percent of local banking assets, and in my hometown, the capital

of Nashville, that percentage jumps to more than 80 percent.

Consolidation has in many ways benefited not only the institutions involved, but also the consumers. But my colleagues and I

also worry about declining diversity in our banking system and

about the forces driving this latest round of consolidation. A steady

stream of new bank charters and conversions has partially offset

the number of institutions lost to mergers over the past several

years. However, as I mentioned before, the banking system’s assets

are increasingly concentrated in a small number of institutions

held by a national charter.

Our Nation’s financial system and its financial services policies

have always emphasized the need for diversity, balance, and opportunity. Our State banking system encourages entrepreneurship,

creating opportunities for new credit providers to enter the market

and to find new ways to serve their communities.

Senators, State banks in Tennessee and nationwide are very

healthy. The State banking system, however, faces a threat, and I

ask your help today in restoring the necessary balance.

A key element of this balance is the question of Federal preemption of State authority. Federal preemption can be appropriate,

even necessary, when genuinely required for consumer protection

and competitive opportunity. But few matters of Federal preempVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 24910.TXT SBANK4 PsN: SBANK4
15

tion meet this high standard. One that did was the permanent extension of the FCRA amendments, which we congratulate you on

enacting last year.

The Comptroller’s recent actions do not seem to meet this standard. The regulations usurp the power of the Congress and stifle

States’ efforts to protect our citizens. They threaten not only the

dual banking system but also the public confidence in our financial

services industry. They also seem to encourage consolidation

among our largest institutions, concentrating financial risk in a

handful of gigantic institutions that may become, if they are not already, not only too big to fail but also perhaps too big to supervise

effectively.

Maintaining a local role in consumer protection and a strong

banking system is more important than ever in the wake of the

current rounds of mergers among our Nation’s largest financial institutions. Centralizing authority of financial power in one agency

or a small group of narrowly regulated institutions would threaten

the dynamic nature of our economy.

The State banking system is now stronger in many ways than it

was 10 years ago before the passage of the interstate branching

and financial modernization. The States have developed models for

interagency information sharing, cooperation, and coordination that

benefit the entire financial services industry.

Our work shows that the dual banking system remains a vital

and essential dynamic for promoting new financial services while

offering new approaches for consumer protection. Our dual background acknowledges the needs of multi–State banks and financial

service firms while protecting consumers. We have worked hard to

develop a system of supervision that allows for innovation while

ensuring safety, soundness, and economic stability. The strong condition of our 6,400 State-chartered banks and 400 State-regulated

offices of foreign banks is the best evidence of our success.

CSBS looks forward to working with the Congress to find additional ways to address the needs of an evolving nationwide financial services system in a way that maintains the strong condition,

minimizes unnecessary regulatory burden, and ensures that all

Americans retain their access to the broadest possible range of financial opportunity.

At CSBS, we look at this relationship very much in partnership

not only with the Congress but also with our Federal counterparts.

And given the history and importance of the dual banking system,

we again thank you for the opportunity to testify today on the condition of the State banking system.

Chairman SHELBY. Thank you.

Chairman Greenspan, I cannot resist this question, since you are

the Chairman of the Fed. Do you still feel optimistic about the

economy? And do you agree with most economists that we will continue to add jobs in the next 5, 6, 7, 8 months?

Chairman GREENSPAN. I do, Mr. Chairman.

[Laughter.]

That is what I wanted to hear from you.

[Laughter.]

Chairman SHELBY. But only that is in keeping with about dozens

of other economists. You are an economist that feels that we are

16

going to add on average 180,000 jobs a month. I know it will come

down and go up some. Do you agree with that, or is that guessing?

Chairman GREENSPAN. Mr. Chairman, I do not want to get into

specific numbers. Indeed, I am going to be getting into these data

in some detail tomorrow before the Joint Economic Committee.

Chairman SHELBY. I know.

Chairman GREENSPAN. However things are changing. We evidenced some slowing down in the middle of the first quarter, and

it is fairly apparent from the data since that things have picked

back up again. March was a good month. We moved into April with

retail sales doing reasonably well. Motor vehicle sales looked as

though they were doing quite well in the beginning of the month.

New orders are moving along at a reasonably rapid pace.

Chairman SHELBY. Does that include durable good orders?

Chairman GREENSPAN. Basically durable goods.

Chairman SHELBY. Okay.

Chairman GREENSPAN. It is more anecdotal than it is statistical

at this particular point, but the anecdotes are fairly convincing at

this particular stage.

It is fairly apparent that pricing power is gradually being restored, and as I will indicate tomorrow, threats of deflation, which

were a significant concern last year, by all indications are no longer

an issue before us. But, clearly, it is a change that has occurred

in recent weeks, and it is a change, as best I can see, that has been

long overdue and most welcome.

Chairman SHELBY. Are you concerned about some of the commodity pricing? I know that is just part of the PPI and CPI.

Chairman GREENSPAN. Yes, we are looking at the full detail of

the cost structure, of which the commodity price inputs are a relatively small part. And remember that more than two-thirds of the

consolidated, underlying domestic costs in the United States are

unit labor costs. And, clearly, the productivity patterns that we

have observed in recent months are still quite impressive and still

not fully understood by us. We know what is happening and we

know why it is happening, but we have very little capability of projecting into the future how this is all going to resolve.

So the inflationary pressures will be reasonably well contained,

so long as productivity is moving at a reasonably good clip. And

unit labor costs, as best we can judge, are still going down, but

going down at a slower rate than they had previously.

There are a lot of data that are involved in putting all of this together, and I will try to make it clearer tomorrow, and go over into

some detail about the mix of issues of costs, jobs, pricing, and the

like, and try to suggest where we think we are coming out, with

the full recognition that in periods like this, forecasting is less than

perfect.

Chairman SHELBY. It is maybe an art and a science.

Chairman GREENSPAN. Yes, sir.

Chairman SHELBY. Do you feel good basically from what you

have said about the overall thrust of the economy, putting it in the

total picture?

Chairman GREENSPAN. I do, Senator.

Chairman SHELBY. Thank you.

17

I want to touch quickly on Basel. Chairman Greenspan, Basel II,

we had a hearing about a year ago, I guess it was here, and there

were some differences of opinion on Basel. Senator Sarbanes and

I were in Europe back in August, and that was raised everywhere

we went, other than Sarbanes-Oxley. Those were the two main

issues we talked about. But do you feel real good about Basel II?

Are you still looking at it to see how this model will work that they

propose?

Chairman GREENSPAN. Well, I think it is important to recognize

certain issues that created Basel II, indeed created Basel I. The

international financial community is advancing at a fairly impressive clip. The changes have been unquestionably to the benefit of

the United States and the rest of the world, and it is in our interest to see if we can create a regulatory structure which essentially

produces a level playing field throughout the world.

This basically means that we have really three choices in front

of us: One, we can stay with Basel I. The problem with that is that

it is increasingly obsolescent and increasingly unrelated to the extraordinary changes that have occurred in the banking system in

recent years. We can go to Basel II, which is where we want to go.

Or we can decide we cannot do anything and go back to the preBasel I period, which, in my judgment, would be very dangerous

so far as the structure of international finance is concerned.

Since I rule out Basel I, my general conclusion—and that of my

colleagues, and I trust the rest of the international banking community—is to make Basel II work. It is not an easy job, as my colleagues have indicated to you here. But we are all working together

to make certain that whatever comes out works for the United

States.

None of us, as I understand where we all stand, will recommend

to the Congress something which we do not believe is to our advantage, indeed to the advantage of the international financial community, or, most importantly, that will not work.

Chairman SHELBY. Mr. Hawke, many, if not most, of the Basel

II participant nations do not have minimum capital requirements.

Is it possible that the Basel II Accord, the new Accord, will start

us down a path toward elimination of that leverage ratio?

Comptroller HAWKE. I certainly hope not, Mr. Chairman.

Chairman SHELBY. Is that one of your concerns here?

Comptroller HAWKE. I have concerns about Basel, but I want to

state emphatically that we will not do anything that erodes or impairs the vitality of our existing Prompt Corrective Action regime.

I think it is enormously important, and it is one of the things that

distinguishes our system of bank supervision from that in other

countries. I think it is enormously important for us to maintain

that regime.

The big unknown in Basel II right now is exactly what the impact is going to be on banks’ capital. That is one of the reasons that

we have been very insistent on conducting a fourth quantitative

impact study.

Chairman SHELBY. Mr. Powell, do you have a comment on that.

Chairman POWELL. I could not agree more. I think the minimum

regulatory leverage capital ratio is critically important.

Chairman SHELBY. Mr. Gilleran.

18

Director GILLERAN. I agree.

Chairman SHELBY. Mr. Dollar.

Mr. DOLLAR. Credit unions are not under Basel.

Chairman SHELBY. I know that.

Mr. DOLLAR. But, we would like to talk about a risk-based capital standard for credit unions.

Chairman SHELBY. But you are interested in capital.

Mr. DOLLAR. We are, and we are interested in risk-based capital.

And I think although Basel is not a proper fit for credit unions because it is oriented more toward for-profit institutions, I do think

the need to get away from a one-size-fits-all prompt corrective action for credit unions over into a risk-based system is good public

policy.

Chairman SHELBY. Mr. Lavender, have you studied this issue,

Basel II?

Mr. LAVENDER. Mr. Chairman, I have not studied it, but I know

CSBS has been pleased and proud to be at the table to discuss it

with our Federal counterparts.

Chairman SHELBY. Senator Reed.

STATEMENT OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman.

Chairman Greenspan, taking the opportunity to ask you a question about the overall economy, it seems that personal wages increased by less than inflation in 2003, and that real wages fell by

about 0.3 percent. This is in contrast to those stories we all read

about very high compensation, nonwage compensation for executives and other wealthier individuals.

Are you seeing an economy that is becoming bifurcated, that

working families who are working for wages are seeing their pay

diminish while those individuals through their talent or luck or

whatever, who are at the top of the organization chart, are reaping

extraordinary benefits? And is not that a concern if that is the

case?

Chairman GREENSPAN. Senator, I am concerned about the increased concentration of income, but the major problem is not in

the very few people who are at the top, but the significant income

differences that are emerging in this country between the highly

skilled workforce and those with lesser skills. I addressed this

issue in an earlier presentation, and the point I tried to make is

that we seem to be exhibiting a marked change over the past 20

years in which as the technology of the capital stock of the United

States moves forward at a very rapid pace, the level of skill of our

workforce on average is not moving up comparably. And a consequence, we are turning out to have a shortage of high-skilled people and, hence, an increase in their relative wage, which shows up

very significantly in increased premiums between college-educated

workers and those with a high school or less educational experience.

And what this means basically is that there is a large number

of people below the median income whose real wages have not

changed at all over the last 20 years. And it strikes me, as I have

indicated in other testimonies, that it is important that we confront

this issue, enhance the capability of our educational system to efVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 24910.TXT SBANK4 PsN: SBANK4
19

fectively move a significantly larger number of people through our

high schools and into colleges where their educational capabilities

will bring them higher skills, and increase the supply of highly

skilled workers, which will bring down their relative wage and decrease the excess supply of people with lesser skills and raise their

wages.

So, yes, I am concerned, Senator, that there is an increasing concentration of income, and that is not good for a democratic society.

I think the issue is broader than the relatively small group whose

incomes, as you point out quite correctly, have gone up very materially relative to the average. But I think that is a small part of

a much larger problem.

Senator REED. Well, there is, I think, a further complicating element. I think the theory that most of us have is similar to yours,

Mr. Chairman, which is if we just educate our people better, they

will be increasingly competitive in the world market. But that is

being confounded now by this question of outsourcing, whereas I

think the image of most of my contemporary back in Rhode Island,

if their son or daughter got a good degree as an accountant, they

would be all set because that is college and beyond. Then you read

where more and more tax returns are being prepared in India and

other places.

I believe in a closed system your remedy might work, but this

system is not exactly closed any longer. And I also think it adds

further complexity to the dilemma you have charted.

Let me just follow that line of questioning with a very specific

question to Mr. Hawke and his colleagues, and that is, there is indication now that there are third-party vendors abroad that are

working for financial institutions in the United States, which raises

issues of privacy. In fact, I have a story—this is medical privacy,

but it is a story about a woman in Pakistan who is protesting her

pay by indicating that she would post the private medical records

of people on the Internet if she did not get paid, which is cyberextortion. But that is an example, probably a very melodramatic

example, of what could happen.

But, Mr. Hawke, what are you doing to ensure that customers

are being notified if their records are being sent overseas, and regulation, are you inspecting facilities overseas to ensure that privacy

is maintained?

Comptroller HAWKE. We have done a number of things, Senator

Reed. We have put out several advisories to our banks about making appropriate risk assessments concerning the maintenance of

privacy with respect to customer records and security of customer

records, where processing has been outsourced to foreign servicers.

This is an issue that we have focused a fair amount of attention

on. It is also an issue that the Basel Committee is considering

through one of its subsidiary organizations.

Senator REED. My time has expired. Could I ask the rest of the

panel to submit a response to the record about what your agencies

are doing with respect to this, Mr. Chairman?

Chairman SHELBY. Absolutely. You want to do it now?

Senator REED. Mr. Gilleran has a comment.

Chairman SHELBY. If you want to comment, do it now.

20

Director GILLERAN. Senator, outsourcing to another country is no

different than any of the other outsourcing that a financial institution or any other company is doing, but when you are dealing with

the public the way banks are, financial institutions must satisfy

themselves that whoever they outsource to have the controls and

the procedures that are necessary in order to properly deal with

the customer relationship. So therefore, regulators are going to be

expected in the future, in my opinion, to be able to satisfy themselves that outsourcing to foreign countries is as reliable as

outsourcing to an organization in the United States. If they are

not, I think it calls into question whether or not that outsourcing

is appropriate.

Senator REED. Thank you.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman.

Chairman Greenspan, the Federal Reserve Bank of Dallas wrote

an article in their January/February issue of Southwest Economy,

title ‘‘Small Bank Competitors Loom Large,’’ which discusses the

problems small banks are facing. In your testimony you talked

about pressure small banks are facing. What can be done to help

small banks both through regulation or statute, which are critical

to the financial institutions and health of my State, the smaller institutions in my State?

Chairman GREENSPAN. Senator, I think that the community

banking industry of the United States is one of the jewels of the

international financial system in the sense that it does not really

exist anywhere else, and has served us exceptionally well, and I

think it is very important that we continue to support that system

as it goes forward.

I am concerned, as all regulators are, that these institutions are

particularly vulnerable to heavy regulation, because they do not

have staffs and cost structures which enable them to address it. It

is important that we be careful in balancing how we regulate these

institutions because it is important that they continue viable and

support our communities, which in large measure they have done.

This is not a simple issue because we have numbers of regulations that apply to all banks and the ability of differing banks to

handle them must be judged in a manner that, one; advances the

purposes of the laws which the Congress has put forward, but second; does so in a manner which is most efficient and effective in

maintaining the stability of our system.

Senator BUNNING. This is a question for anyone who would like

to answer it.

Director GILLERAN. Senator, just to respond, we did a study in

the last year to determine why certain thrifts do better than others, and it is very interesting that we isolated about 87 thrifts

under a billion dollars in size, and these thrifts have been able to

achieve in excess of 1.50 on assets over a long period of time, in

excess of 10 quarters, and they all have some very interesting similarities. One is they are very well-diversified, that is, they are in

all kinds of lending. They offer all kinds of products, but in addition to that, they are extremely well-managed, and their boards of

directors are very strong, and on top of that, they have excellent

21

relationships with their regulator, which is a similarity which we

like to see, of course, but these institutions are institutions that are

flourishing because of good business practices, and therefore, we

are quite confident about the ability of smaller institutions to compete and survive.

Senator BUNNING. So you call an institution, a thrift under a billion dollars small? In other words, my $15 million bank in Northern Kentucky, what is that?

Director GILLERAN. That would be in the same group, but I mean

it is under a billion, but some of these institutions are smaller than

a billion dollars.

Senator BUNNING. Yes, they are, a lot of them.

Director GILLERAN. Lots of them are.

Senator BUNNING. In fact, most of the ones in Kentucky are

under a billion dollars.

Director GILLERAN. But still we find the same characteristics

hold true.

Senator BUNNING. Okay. Let me ask all the regulators here, can

any of you give me an update on the steps financial institutions are

taking to guard against terrorist threats, cyber, whatever? Nobody

wants to answer?

Chairman POWELL. I will address it.

Senator BUNNING. Mr. Powell.

Chairman POWELL. There is a joint effort, Senator, among all the

regulators, to make sure that every insured institution has in place

policies and procedures that will deter any cyber or any other information breakdown by terrorists. The FDIC has sponsored some

symposiums, as recently as last week, that was in cooperation with

all the regulators, wherein we bring bank management, directors,

and interested parties together to in fact make them aware of procedures and policies that would inhibit any terrorist strike against

the system. I think there is a keen awareness among the regulators, I think among all regulators, and part of it is an educational

effort and part of it is working with other regulatory agencies within the Federal Government and also the State governments.

Senator BUNNING. My time has expired.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Senator Crapo was here earlier.

Chairman SHELBY. He is going to defer to you because you were

here earlier, Senator Crapo.

Senator CRAPO. Thank you very much, Senator.

I would like to first direct a question to Mr. Powell, Mr. Gilleran,

and Mr. Lavender. As I indicated when I came in, I am very focused on the regulatory reform legislation we are developing. One

of the issues there relates to industrial loan banks, and the question I have is that concerns have been raised about the fact that

owners of industrial loan banks are not regulated as Federal bank

holding companies. Some critics have charged that industrial

banks, their depositors, and perhaps the deposit insurance system

are endangered by the bank’s affiliation with unregulated parent

companies. Can you describe the regulatory regime that applies to

industrial loan banks and their parent companies and what authority do the FDIC, OTS, and State banking regulators have to look

22

into activities of industrial banks, holding companies, and their affiliates?

Mr. Powell.

Chairman POWELL. Yes, Senator. Our safety and soundness examination is not any different with industrial loan companies than

it is with any commercial bank. The same procedures, policies that

we adhere to at the FDIC are applied to examinations conducted

at the ILC. I am convinced that we have the ability at the FDIC

and the willingness to make sure that we examine those institutions from a safety and soundness standpoint as we would any

bank.

Furthermore, we are not restricted by law, and we will from time

to time enter into the parent, and look at the parent’s situation and

have questions and answers as it relates to their support of the insured institution. There is no barrier there that I can detect at all.

Senator CRAPO. Thank you.

Director Gilleran.

Director GILLERAN. Senator, we have 650 holding companies that

the OTS is responsible for, and some of those holding companies

own industrial loan companies, and we have the same supervisor

role responsibilities for those holding companies that we have for

the ones that own thrifts, and we examine them in the same fashion and we have the same authorities over them as we would have

under any holding company situation. So our authorities are complete.

Senator CRAPO. Mr. Lavender.

Mr. LAVENDER. Thank you, Senator. I agree with both of my colleagues here at the table. There are only a handful of States that

actually license ILC’s. Tennessee in fact is not one of them. However, the CSBS and the States that do regulate them, look at them

no differently than the other institutions that regulate and work

very closely with our Federal counterparts to apply the same standards of safety and soundness.

Senator CRAPO. Thank you.

Mr. Greenspan, for years industrial loan banks have had authority to basically offer NOW accounts to individuals and corporations.

In the context of the question that I just asked of Mr. Powell, Mr.

Gilleran, and Mr. Lavender, are you aware of any risk of threat of

injury to depositors, competitors, or the deposit insurance system

as a result of the way this industrial loan bank system operates?

Chairman GREENSPAN. I do not think that is where the problem

that concerns us resides.

Senator CRAPO. Please elaborate.

Chairman GREENSPAN. I was looking at some of the commentary

that I have been involved with over the years, and if I may just

read a note that relates to this, it is something that is part of the

testimony I gave before this Committee in 1998, relating to the

issue of whether or not we should open up the prohibition between

commerce and banking. The general view that the Federal Reserve

had at that time would best be described by part of my testimony,

which said that technology was in the process of eroding any bright

line between commerce and banking. Nonetheless, we concluded

that the free and open legal association of banking and commerce

would be a profound and surely irreversible structural change that

23

should best wait while we absorb the significant changes called for

by financial modernization.

Since Gramm-Leach-Bliley passed, which is essentially moving in

the direction that the testimonies back in 1998 were indicating, the

key issue here is that arguments relevant to industrial loan companies concern how far the Congress wishes the banking system to

move toward increased integration of commerce and banking.

As I indicated back in 1998, over the very long run that is going

to happen largely because of the technological changes which inevitably are going to occur and alter irreversibly the structure of

finance. But I think we have not given the existing Gramm-LeachBliley Act and all of the other types of regulatory structures which

the Congress has put in place, a chance to work, to see how this

gradual evolution is evolving, recognizing that once we move in a

direction, it is very difficult to reverse. So my judgment is that

what we need here is caution, and what the ILC issue ultimately

comes down to is breaching the line between commerce and banking, and that I think is premature.

Senator CRAPO. Thank you very much. I see that my time is up,

and I will not go further at this point. I do appreciate the answers

that you gentlemen have given me on one of the critical issues we

deal with in reg reform.

Mr. Chairman, if I could, I would like to just ask one question

of all members of the panel, that I would ask that they respond to

in writing, if I could do so. That is, as has been indicated, we are

in the process right now of putting together a regulatory relief

package, and we have here in front of us virtually all the regulators. I would just like to ask each of you if you could respond to

me in writing, and to the Committee in writing, about what you

believe the top two or three items that we should consider in a regulatory relief package should include.

Chairman SHELBY. Senator Crapo, would you include your request, respond to you because you are the leader here, but also to

the Committee Members?

Senator CRAPO. Yes. In fact, I meant to say that, Mr. Chairman.

Chairman SHELBY. Will you all do that?

Senator CRAPO. Thank you very much.

Chairman SHELBY. Thank you, Senator Crapo, and I thank you

for your leadership in this area because as I said earlier before you

came in, there are so many regulations and a lot of laws, that we

wonder what they are still doing on the books, do we not? Because

Chairman Greenspan talked about, and all of the witnesses have

talked about, how far the financial service industry has moved in

the last 10, 12 years, or the last 5 years.

Senator Sarbanes is recognized.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman. Before

I turn to the panel, I want to commend you for scheduling this

hearing. It has been my long-held view that the oversight function

of this Committee is actually one of its most important responsibilities, and it is very clear that is a responsibility you take very seriously, and this is but one in a series of hearings you have held adVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 24910.TXT SBANK4 PsN: SBANK4
24

dressed really to meeting the Committee’s oversight responsibility,

and I want to thank you for that focus.

I want to just follow up on Senator Crapo very briefly before I

turn to the other areas I had here. Mr. Powell, is it your position

that the FDIC conducts regular, annual holding company examinations? I know the Fed does, but I was not under the impression

that the FDIC does so.

Chairman POWELL. Is it the holding company of the ILC’s you

are referring to, Senator?

Senator SARBANES. Do you do regular, annual examinations of

the holding company?

Chairman POWELL. No, sir.

Senator SARBANES. I mean the process you follow does not begin

to be the equivalent in terms of reviewing banking practices to the

one that is followed by the Federal Reserve; is that correct?

Chairman POWELL. That is correct. I was referring to the ability

to look into the ILC’s parent company.

Senator SARBANES. But you do not review on a regular basis the

holding companies that have ILC’s in them, do you?

Chairman POWELL. We do not.

Senator SARBANES. Does the Fed review them on a regular basis,

Chairman Greenspan?

Chairman GREENSPAN. You mean the ILC’s?

Senator SARBANES. No, the holding companies that hold the

ILC’s.

Chairman GREENSPAN. Yes, we do.

Senator SARBANES. That is what I thought.

Now, let me ask, I want to go to this issue of money laundering

first and how effective the regulators have been in overseeing and

giving proper priority to compliance with the Bank Secrecy Act, especially the rules of Title 3 of the USA PATRIOT Act. Of course,

this is designed to counter money laundering and the financing of

terrorism, but I think it can only be effective if its mandates are

not an afterthought but that the regulators are testing the adequacy of bank reporting and recordkeeping in real time.

Just on Sunday,the Washington Post had a report about the asserted failure of Riggs Bank to follow the Bank Secrecy Act’s suspicious transaction reporting rules in a case involving possible

ramifications for U.S. antiterrorist efforts. They state ‘‘FBI scrutiny

of Riggs’ international business began soon after the September 11,

2001 attacks,’’ but according to the article, the inquiry ‘‘widened to

include parallel probes by the OCC and Riggs itself after a Newsweek report in November of 2002.’’ The article goes on. It says ‘‘in

the course of the inquiries, bank and Federal investigators found

tens of millions of dollars in questionable transactions that had not

previously been reported. That led to the flurry of suspicious activity reports filed by the bank.’’ But the article also stated, ‘‘Riggs

failure to file reports had been noted by regulators years ago, but

no action was taken. In annual bank exam reports for 1999, 2000,

and 2001, OCC officials outlined problems in Riggs’ procedures to

guard against money laundering or other illicit activities by bank

customers, but the OCC never fined or sanctioned the bank,

sources familiar with the examinations said.’’

25

Comptroller Hawke, obviously, you are first in line to address

this question. What is your comment about this article which just

appeared, especially about the relationship between the annual examination reports and what appears to be a delay of extensive examination in this area until 2002? How does a situation reach this

point in a bank that is subject to continuous examination, and that

does a significant level of international business?

Comptroller HAWKE. Senator Sarbanes, I am a bit limited in

what I can say about Riggs specifically, because it is a matter of

ongoing enforcement action by the OCC. But I can say that, particularly after September 11, there was increasing concern about

the internal controls over one segment of Riggs’ banking operations

and increasingly heavy emphasis by the OCC on taking corrective

action. Last year, we did get a consent cease-and-desist order from

Riggs that was intended to bring about significant change in the

way that they administer certain aspects of their business, and it

is a matter of ongoing enforcement involvement by the OCC.

Senator SARBANES. You have a 25-page written testimony here

today. I admit I skimmed it but maybe I missed it. You could correct me, but I did not see any mention of the Bank Secrecy Act or

any efforts by your agency to implement Title 3 of the USA PATRIOT Act to combat terrorist financing.

I do not know what message that sends to the banks, frankly.

Comptroller HAWKE. Implementation of the USA PATRIOT Act

is a matter of high priority, not only for us, but for all the agencies,

and we are working on an interagency basis in the promulgation

of a variety of regulations that are called for under the USA PATRIOT Act.

In response to questions that Chairman Shelby raised at the

hearing 2 weeks ago about Bank Secrecy Act concerns, yesterday

I delivered a letter to the Chairman addressing some of those

issues in great detail, and I would request that that letter be made

part of the record, Mr. Chairman.

Chairman SHELBY. We will ask that it be made part of the

record. We will share that with all the staff and Senator Sarbanes.

We are both interested in this, in noncompliance of the Bank Secrecy Act.

[Letter of Mr. Hawke:]

Chairman SHELBY. Do you have some more questions?

Senator SARBANES. I will defer to Senator Carper.

Chairman SHELBY. Senator Carper.

STATEMENT OF SENATOR THOMAS R. CARPER

Senator CARPER. Thanks, Mr. Chairman.

To each of our witnesses, welcome. It is good to see all of you.

Earlier in the hearing, Mr. Chairman, you asked a question of,

I think it was Chairman Greenspan, and he gave a two-word answer to that question, and the words that he answered in response

to your question were: I do.

A number of years ago, Chairman Greenspan probably said those

same 2 years to a woman named Andrea Mitchell, who is being

honored this Saturday evening along with some other truly remarkable people from around the world at the Commonwealth

Awards in Wilmington, Delaware at the Hotel Dupont. This is

26

about the 25th year we have had the Commonwealth Awards. I

just wanted everybody to know he said ‘‘I do’’ more than just today,

and he said it to good effect at least on one other occasion. I know

you are proud of her, and we look forward to hosting her, and

maybe if we are lucky, maybe even you too. Congratulations, and

convey that to her.

What I would like to do is revisit some of the comments of Mr.

Lavender. What do they call you back in Tennessee?

Mr. LAVENDER. Commissioner. My wife calls me Kevin though, so

whatever your please, Senator.

[Laughter.]

Senator CARPER. Robert Glen is our Commissioner of Banking. I

do not know if you know him, from Delaware, but he is a very able

person. I was privileged to appoint him when I was Governor of

Delaware.

There was some back and forth between you and the Comptroller

of the Currency, and Mr. Comptroller, good to see you too today.

I am not going to ask Mr. Powell or Chairman Greenspan to referee this disagreement, but I would ask for them just to share their

thoughts with us as the OCC preempts the ability of States to have

the kind of say they have had in the past on State-chartered banks.

Let me just ask Chairman Greenspan and Chairman Powell if

you have any thoughts with respect to the impact on the dualbanking system, of what is transpiring on this front?

Chairman GREENSPAN. Senator, this is an issue which is really

a question of the law, and courts at some point will resolve it. My

only concern relevant to this issue is that however it is resolved,

it not undercut the dual banking system which has been so critical

an element in the development of banking in the United States and

continues to be so.

The dual banking system is a very unusual competitive structure

for regulation, and it has served us well, and I am concerned that

however we develop issues in the years ahead, that we be careful

to maintain the appropriate balance of regulation between State

and Federal agencies.

Senator CARPER. Mr. Powell.

Chairman POWELL. I agree with Chairman Greenspan that the

dual banking system is vital to the banking industry in America.

I, at one time, owned a State-chartered institution, and at one time

had a national-chartered institution. I think it is also important to

note that there continues to be strong appetite in the marketplace

for a State banking charter, so that tells me the market perceives

that there are some benefits to having a State banking charter.

Also, I think it is important that on the issue of deposits and

loans that there be national standards. I think it is important the

way our society is today, as mobile as we are through interstate

commerce, that those issues, deposits and lending, that we have

some uniform standards. I also think it is important—and I understand and recognize that certain States, through their elected officials and legislatures, will have unique laws particular to that

State, that do not necessarily deal with loans and/or deposits in

interstate commerce. So, I recognize and understand that also is

important.

27

But the dual banking system is one of the things that distinguishes I think America from the rest of the world, that we should

protect and that we should encourage it to continue to thrive.

Comptroller HAWKE. Senator, could I add one point? This is obviously an issue as to which there are deeply held views on each side.

Senator CARPER. I am starting to gather that.

Comptroller HAWKE. I wanted to refer to a table in my prepared

statement. It plots on a graph the share of commercial bank assets

held in the national banking system. The dual banking system has

been enormously stable for many, many years. Preemption is something that has been around for as long as the national bank system

has existed, 140 years, so it is not a new concept. The national

bank share of total commercial bank assets has remained very,

very steady over many years. For the past 15 years it has been at

about 56 to 58 percent. It has held very stable, and we do not see

any reason to think that there are going to be changes in that equilibrium that has existed for so long.

Senator CARPER. Commissioner Lavender.

Mr. LAVENDER. Senator, you are absolutely right. I have only

been a regulator for 15 months now, after having been a corporate

lender with both a national-chartered institution and a State-chartered institution for 14 years.

I would say the Comptroller’s chart after this year will change

dramatically. Being in this position for 15 months, I can attest and

testify for you today that there have been at least 50 instances

where national-chartered institutions or their subsidiaries have either turned in their charters or licenses to State regulators, or put

us on notice that they would be supplying those to us, and those

are institutions that range from the $15 million that this Senator

mentioned over here, to as much as a billion dollar plus institutions. I think this charter is a little deceptive today. The preemption that was issued by the Comptroller’s Office is far sweeping. It

takes away the ability of States not only to enforce consumer rights

regulations and laws, but also the capability to do things such as

predatory—let me back up and say I agree with Chairman Powell.

As a former banker, I think there should be a national standard,

but I do not think the Comptroller’s preemption, the rule that went

into effect on February 12 goes far enough.

When you say predatory lending in particular in this case, that

the standard is simply do not lend based on the borrower’s inability

to repay, I do not think that goes far enough, when in today’s environment we have all talked about historically low interest rates.

Gentlemen, when there is a citizen of the State of Tennessee, that

comes in and has a loan that in today’s market is 24 percent, she

had to pay 5 points to get in the loan, she has a prepayment for

7 years, that is predatory lending.

As a new State regulator I would love the ability to set the

standards with my Federal counterparts of what in fact defines

predatory lending, what we can do jointly as Federal and State regulators to combat it, but I just do not think the Comptroller’s rule

goes far enough to protect the citizens, not only the great State of

Tennessee, but also across the country.

Senator CARPER. My thanks to each of you.

Thanks, Chairman Shelby.

28

Chairman SHELBY. Senator Corzine.

STATEMENT OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman.

To all the participants, welcome, and thank you for being here.

My first question is, I would love to hear what the broad conceptual differences between Basel I and Basel II are, that we have had

hearings on, and tried to have conceptualized to those of us that

are a little farther away from the markets and do not fully understand. My question will get at whether we think risk-based capital

is really the way that regulatory structure should be applied to financial institutions’ balance sheets, what circumstances would lead

us also to have second-tier requirements like leverage rules?

Comptroller HAWKE. Let me take a crack at that. Senator

Corzine, Basel I was a first effort at risk-based capital rules, and

I think there is fairly general acceptance of the conclusion that it

was a very coarse attempt. Various types of bank assets were classified into several risk buckets, and that was essentially the endall of risk-based capital. The experience since Basel I has been that

those buckets do not accurately reflect risk and they are easy to

game.

Basel II takes some very different approaches to risk-based capital. It looks at probabilities of default, exposure at default and loss

given default, and calculates capital requirements under some

much more sophisticated formulas. It also takes into account credit

risk mitigation, that is, the extent to which risk may be mitigated

by various devices, such as guarantees, collateral, and the like. It

also takes into account operational risk, which is a subject that has

been recognized by banks themselves for many years but has never

been embodied in regulatory capital requirements. All told, I think

that the basic conceptual differences between Basel I and Basel II

are that Basel II takes a much more sophisticated and, frankly,

much more complicated approach to the development of regulatory

capital rules.

You asked about the leverage ratio, and we discussed that a little

bit earlier. I think we probably all share the view that the leverage

ratio is an exceedingly important component of our approach to

bank supervision. One of the concerns that has been raised is

whether Basel II will reduce bank capital requirements to a point

where the leverage ratio becomes the binding constraint, in other

words, where capital ratios calculated under Basel II fall below the

leverage ratio. An issue has been raised as to whether that will put

pressure on us to reduce the leverage ratio in the interest of assuring that U.S. banks will not be put at a competitive disadvantage

vis-a ́-vis foreign banks that do not have a leverage ratio.

I think we probably all share the view here that the leverage

ratio is an essential component of Prompt Corrective Action on

which our whole system of bank supervision is based. If we find

that Basel II does result in the lowering of regulatory capital requirements below what would be required by the leverage ratio, I

am perfectly prepared to go back to the Basel Committee and seek

recalibration of the capital requirements so that we do not have

that anomaly.

29

Senator CORZINE. You would argue to raise the risk-based capital

rules to conform with the leverage rules?

Comptroller HAWKE. I think that is what we would be faced with.

Otherwise, our banks would be put at a competitive disadvantage

vis-a ́-vis banks in countries that do not have a leverage ratio, and

reducing the leverage ratio would undermine our whole system of

Prompt Corrective Action, which is the foundation stone of our system of supervision.

Senator CORZINE. I would love to hear others’ comment on this,

but does that not strike at the heart of the value of risk-based capital, presuming that one has been intelligent enough to actually

create a rule that reflects the various risks associated with managing a financial institution?

Comptroller HAWKE. I think there may be something of a disconnect there, but the leverage ratio and Prompt Corrective Action

for more than 10 years have been the foundation stone on which

our system of bank supervision is based. That reflects a fundamental difference between the United States’ approach to bank supervision and that in most of the other Basel countries. I think we

need to reach an appropriate accommodation where we try to make

our basic system of regulatory capital rules more risk sensitive, but

we should not do that at the price of dismantling or significantly

impairing the basis for our supervision of U.S. banks.

Senator CORZINE. Anyone else like to comment?

Chairman POWELL. Senator, I think your comment is well said.

That is assuming however that the models are perfect. I think the

process will be dynamic as it goes forward. There will always be

tweaking of those models based upon market conditions, based

upon history, what we have got wrong. I think we all agree that

those models are a marked improvement, but they are not an end

to themselves. That is the reason we need the minimum regulatory

capital.

Senator CORZINE. Mr. Chairman.

Chairman GREENSPAN. I think the Senator has raised a fundamental question here because at roots, a risk-based system is an

evolution from the earlier versions of any form of leverage-based

system, and at the end of the day they are mutually exclusive. I

think the problem, as the Senator is implying, is that we are in a

transition stage, and as I think we all have to be aware that, at

the end of the day, we would like our regulatory system to essentially merge into the economic-based system of risk management

that the larger, more risk-managed institutions have. I think the

question here is how, in this interim stage where we are still developing the technology and the economics of the type of risk management which is implicit in the Basel II system, do we manage this

in a manner which does not create problems? Obviously you cannot

manage the type of rules which the FDIC of necessity has to focus

on, in a wholly risk-based system. But I do think it is important

not to think that we are trending toward some merger of a leverage

ratio and risk-based capital systems. That is not possible. I think

it is a question of how we do it.

Senator CORZINE. It is just a matter of when the conflicts will

occur, as we certainly have seen, I guess in the discussion of GSE’s

in particular, but these are really challenging elements because if

30

one become preemptive of the other, and I think in many ways potentially undermines the credibility of the other because it sets a

different kind of floor.

I will end here, Mr. Chairman. I will say though that the complexity of the risk-based models, which I am fully supportive of, reflective of underlying economics, are really quite difficult for those

of us that sit on this side of the table, maybe even on that side of

the table, to understand whether they actually fit the reality of the

circumstances that meet in the complexity of a balance sheet today,

but it seems to me we are posing a major dilemma if we have a

leverage ratio overlaid on top of a risk-based system.

Chairman SHELBY. Senator Schumer.

STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman, and I want to

thank our witnesses. My first question is to Comptroller Hawke. It

is about the Riggs Bank situation. I have been very concerned

about what has been going on here. You know that earlier this year

the State Department revoked or refused to renew visas for 16

Saudis who were here under diplomatic cover, but in actuality

worked in a Virginia school that was teaching terrorism. Similarly,

in 2003, American officials deported a Saudi consular official in Los

Angeles. I have a number of questions.

First, did any of these individuals have accounts at the Riggs

Bank or receive money from those accounts? If so, how much?

Second, I would like to know if your review of the Riggs Bank

accounts turned up any untoward activity. In your enforcement action on July 16, 2003, Riggs Bank was tasked with filing suspicious

activity reports within 150 days in relationship to these accounts.

Have these reports been filed? If so, how many?

Then third, just generally, Riggs was passing money in violation

of the Bank Secrecy Act for 2 years until all of this came up. What

are you doing to tighten things up so that there is no future Riggs

Bank doing that kind of thing?

Comptroller HAWKE. Senator Schumer, if we may provide a response to those questions in writing, I would be happy to do so,

with the caveat that I gave a bit earlier. Because Riggs is the subject of ongoing supervisory action by the OCC, we are somewhat

constrained in what we can say publicly about it, but I would be

happy to do the best we can in addressing the questions.

Senator SCHUMER. You could do those, and if you have to protect

specific names, that is fine. I am not interested in the specific

names of the case. I am interested in whether Riggs filed the reports and whether any of these people—I do not have to know

which ones—were involved in the Riggs Bank. Of course, if all 16

were, then you cannot say that, but if it is one or two, you probably

can without revealing identities.

Second question. Hedge fund regulation. There have been two

reasons given for hedge fund regulation, and that is one is to protect investors. I am not terribly sympathetic to that if, and only if,

as they used to say in law school, hedge funds deal with people of

great wealth. In other words, when the hedge funds try to find

ways of getting people to make $5,000 investments, they are going

to make themselves more like mutual funds. But leaving that part

31

aside, someone is putting a million dollars in, caveat emptor is

okay with me. But second is the issue of systematic risk which relates more directly to this hearing, that if we do not have registration, if we do not have regulation, we get something like long-term

credit and other things, systematic risk is a problem.

I would like, I guess the most relevant people are Chairman

Greenspan, Mr. Hawke, and Mr. Powell to talk about those, but

anyone should feel free to answer.

Chairman GREENSPAN. Senator, the hedge fund industry, which

is made up of far more diverse types of institutions than originally

existed, in the context of, as you put it, the million dollar investments, is a major contributor to the flexibility, stability, and liquidity of the overall system. They do not, in my judgment, pose any

significant systemic risks largely because the people who lend them

money, their counter-parties, are large institutions who basically

know what they are doing and the system has worked rather well.

I fully agree with the point that you make that hedge funds

which endeavor to attract retail money in fact become mutual

funds as far as I am concerned, and should be subject to all of the

rules that exist for those institutions.

I do, however, wish to point out that if we endeavor to regulate

hedge funds merely for the sake of regulating hedge funds, it is not

clear to me what the justification is, and indeed, I can see significant losses to the flexibility of our very sophisticated financial system were we to do that. So, I think in moving forward, the criteria

which you point out, Senator, should be the criteria of the type of

regulation which is imposed.

Senator SCHUMER. I think the SEC did cite—I said the word

wrong—systemic risk as one of their potential justifications. Did

they consult with you on that before then?

Chairman GREENSPAN. Not with me specifically. There may be

systemic risks, but I have not found any yet.

Senator SCHUMER. Anyone disagree with that?

Comptroller HAWKE. I would just add to what Chairman Greenspan said, Senator Schumer, that the discipline exerted by counterparties is enormously important here. One of the failings that we

saw in Long Term Capital Management was that counter-parties

were not exercising the discipline that we would expect. Lending

banks were waiving access to information when the borrower refused to give them that information. That is something that can be

addressed through the normal bank supervisory process.

Senator SCHUMER. Anyone else on that subject?

[No response.]

Last question, if I could, Mr. Chairman?

Chairman SHELBY. Go ahead.

Senator SCHUMER. I guess I am asking Chairman Greenspan. In

recent days, last month, as you noted, talking about the economy,

the general condition of the economy seems to have picked up in

a wide variety of ways, whether it is employment with the last

month’s jobs numbers, retail sales, manufacturing, et cetera. It

seems when the markets hear the good news, they have a bifurcated reaction. On the one hand they say, ‘‘Gee, this is good news.’’

On the other hand they say, ‘‘Inflation is around the corner. We

had better watch out.’’ I think that is a reasonable reaction because

32

of the deficit that we have here, which to me is unprecedented in

the short amount of time it has been created. I am wondering in

light of recent market reactions, what your views are on this deficit? I know last time we talked about this, we got into Social Security, which I think is, at least for the near-term, a political nonstarter. The ability to cut Government costs, well, I voted against

the prescription drug bill which was the greatest prescription cost

around, making me a fiscal conservative around this place, but that

has not happened for a while, and it just strikes me, given what

I have seen in the last while, that supporting making these tax

cuts permanent actually hurts the continued recovery, not over a

6-month period but over an 18- or 24-month period, rather than

helps. Could you comment?

Chairman GREENSPAN. The deficit problem that I think should

give us pause is not the short-term one, which is a problem but is

not in and of itself destabilizing. At least the markets certainly do

not read it that way. There is a very significant problem which confronts us in the next decade, and that occurs because the very large

baby-boomer population retires and doubles the aggregate number

of people on various forms of retirement income. As best we can

judge, the uncertainties associates with Medicare specifically are

greater. I should say parenthetically that Social Security is a defined benefit program, it cannot be forecast in exact detail, but

close enough. Medicare cannot. The range of possibilities is in my

judgment sufficiently worrisome that it creates uncertainties in the

longer-term fiscal system which I do not think we have come to

grips with as yet. It has not yet impacted on the short-term markets clearly. You cannot find footprints of either the immediate deficit or the long-term deficit in long-term Treasury yields as yet, but

clearly, you cannot create a fiscal problem of the type that is potentially out there without ultimately impacting on the rate structure

and impacting on economic activity and economic growth.

There are all sorts of elements involved in what level of taxation

you think is appropriate for the longer-term, what level of taxation

creates problems for long-term growth. Those are issues which I

think the Congress has to address at some point, in my judgment,

sooner rather than later.

Senator SCHUMER. Just one follow up. It seems to me, at least

from the few people I have talked to, and obviously, you know

much more about this than I do, that the market’s reaction is not

to the long-term worry about the Medicare and Social Security

problem which obviously loom out there, but have been there for

5 or 10 years, but rather to the short-term, that because of the immediate year-to-year deficits we have even now before the babyboomers retire, that they are greatly worried that the Fed will have

to raise interest rates rather quickly and rather steeply as the

economy begins to take off. Am I wrong in thinking that?

Chairman GREENSPAN. The market commentary clearly is that in

response to the fact that the economy is clearly coming back, and

indeed as I mentioned earlier, the problems which we have confronted and the concerns that we had about deflation last year are

no longer an issue, that there clearly is an emergence of views as

to how this will all balance out. I will try to address that in testimony which I am scheduled to give tomorrow at the Joint EcoVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 24910.TXT SBANK4 PsN: SBANK4
33

nomic Committee, but the news is good. I mean if you look out at

various economic scenarios that could have emerged out of the extraordinary events subsequent to September 11 with the corporate

scandals and wars in Afghanistan and Iraq, we are doing rather

well, and I think the question is, how do we manage that in a manner that we will continue to do well?

Senator SCHUMER. Thank you, Mr. Chairman.

Chairman SHELBY. Thank you, Senator.

I want to get back on the Riggs situation, Mr. Hawke. Do you

believe that the examination process that you have currently in

place is robust enough to ensure bank compliance of the Bank Secrecy Act?

Comptroller HAWKE. I do, Mr. Chairman, and I should say that

we have all learned a lot in recent years about the importance of

making that process even more robust than it is.

The issue, for example, of transaction testing is one that we have

been giving thought to. We do not, as a regular matter, do extensive transaction testing in Bank Secrecy Act compliance. We look

primarily at a bank’s own internal controls, their internal audit,

the way that they manage their own compliance. We take a riskbased approach to it as well; we concentrate on those institutions

that present the highest risk.

Chairman SHELBY. A lot of people that know a lot about fighting

terrorism basically concluded that money, financing of terrorist activities, training, movement, everything, is central to their activities, so this plays right into the regulator, in the Treasury’s hands

as far as your obligation to root this out or try to root it out, does

it not?

Comptroller HAWKE. I think that is clearly right.

Chairman SHELBY. Could you provide to the Committee, Mr.

Hawke, a brief overview of how the issue of Bank Secrecy Act compliance is handled by your examiners? Specifically, do the examiners look at a general program, a list of activities or programs the

bank engages in? Do the examiners ever look at individual transactions to gage a bank’s compliance with the Bank Secrecy Act? Do

you want to do that for the record?

Comptroller HAWKE. Mr. Chairman, that was one of the questions that you raised with us at the last hearing.

Chairman SHELBY. I know.

Comptroller HAWKE. It is addressed in the letter that we delivered yesterday.

Chairman SHELBY. Is it addressed fully? My staff wanted it addressed totally, not cursory.

Comptroller HAWKE. It is addressed in four or five pages of the

letter. We would be happy to supplement that if there are additional questions.

Chairman SHELBY. Okay. Are there other banks besides Riggs,

Comptroller Hawke, that you are currently watching, that have

problems similar to Riggs? Out of your whole banking system,

there are bound to be some.

Comptroller HAWKE. Riggs presented a special kind of situation

because they——

Chairman SHELBY. Because of where they were located?

34

Comptroller HAWKE. Well, in part. They had made a specialty of

embassy bombing——

Chairman SHELBY. That is because of where they were located

too.

Comptroller HAWKE. They did it overseas, as well, but that was

a specialty that they had developed. I think we all recognize that

that product line, if you will, presents considerably higher risks

than other types of banking relationships.

Chairman SHELBY. As far as other banks are concerned, I know

they are here in Washington and they went after a lot of the diplomatic business and so forth, or maybe with the diplomat’s bank

among other things. But there are other banks in this country

under your jurisdiction that I hope you are looking at too.

Comptroller HAWKE. We are, Mr. Chairman, and, as I said, we

take a risk-based approach. We look at a number of different attributes that a bank presents, the extent to which they have foreign customers, the extent to which they are doing private banking,

their location, the number of SAR’s that are filed and so on. All of

that gets factored into the decision as to how much——

Chairman SHELBY. Has the word gone out though from the

Comptroller of the Currency, that it is not business as usual, that

we are in a war against the terrorists and money is important to

the terrorists? Also, is that one of your highest priorities?

Comptroller HAWKE. It is a high priority with us, Mr. Chairman,

with respect to the training and incentivizing of our examiners, as

well as with the banks that we supervise.

Chairman SHELBY. Mr. Powell, what about you?

Chairman POWELL. It is a high priority with us also, Senator.

Chairman SHELBY. Do you have some troubled banks similar to

Riggs, like that, in dealing with the Bank Secrecy Act?

Chairman POWELL. I am sure we do. We have had something

like——

Chairman SHELBY. Would you furnish that to the Committee for

the record?

Chairman POWELL. Be happy to. I think we have had 24 enforcement actions.

Chairman SHELBY. Twenty four enforcement actions.

Mr. Gilleran, you have a lot of banks. I know a lot of them are

all over the country.

Director GILLERAN. A lot of thrifts.

Chairman SHELBY. Well, thrifts and savings banks.

Director GILLERAN. We do not have any that we know of that are

of the nature of the Riggs situation. We do see a problem for some

of the smaller institutions in complying because the laws require

special training for their employees, and special surveillance on the

part of the organization, so that we are giving particular attention

to how this is all being handled by smaller organizations.

Chairman SHELBY. Mr. Dollar, what are your responsibilities for

the credit union?

Mr. DOLLAR. We are not exempt from this one, Mr. Chairman.

Chairman SHELBY. I hope not. Thank you.

Mr. DOLLAR. And although there is not much money laundering

going through institutions as small as credit unions, 60 percent of

which——

35

Chairman SHELBY. We also have some huge credit unions. I

know one in my State is well-run and a couple of billion dollars in

size. I call that pretty good size.

Mr. DOLLAR. Well, you do have, and the point I wanted to make

is that we take it seriously, and we take it seriously to the point

during the 6 years I have been on the NCUA Board, the single

largest conservatorship that we have done of any credit union in

the United States, Senator Schumer, was in your home State, and

it was for Bank Secrecy Act violations. We do take it seriously.

Chairman SHELBY. Senator Sarbanes, thank you for your indulgence. You want to get back into this too.

Senator SARBANES. I have to tell you, David Aufhauser, when he

was General Counsel to the Treasury Department, in testimony before this Committee, said that the Bank Secrecy Act part of the

bank audit might be a stepchild to the rest of the audit and not

receive the priority and primacy it deserves. Aufhauser went on to

suggest that we might be better served if Treasury constituted a

separate examination and compliance force in the area of bank secrecy. What is your reaction to that suggestion by Mr. Aufhauser?

Comptroller HAWKE. I am not sure that the problem of Bank Secrecy Act compliance is going to be addressed by just adding more

examiners to the mix, Senator Sarbanes. I think that the fundamental aspect of Bank Secrecy Act compliance is very consistent

with the fundamental approach to bank supervision generally, and

that is to look, in the first instance, at the extent to which the institution has established the kind of controls and audit processes

that are necessary for it to assure itself that it is complying with

the law. That is the starting point for virtually all bank supervision. It is not by any means the end, but that is the starting

point. And that is the thing that bank examiners are trained to do

and do every day. In the course of several years of dealing with

Riggs, there was an escalating response by the supervisors that

started with a focus on the bank’s own internal controls, on training, and on those fundamental aspects of bank supervision that we

look at in other areas, as well.

Senator SARBANES. Yet, we are talking about the possibility of

terrorist financing here. I mean, it goes from year to year. You are

running along doing these reports every year, but at what point do

you move to really move in there and correct it and make sure that

this is not constituting access to funds for terrorist activities?

Comptroller HAWKE. As I say, there was escalating concern over

a period of several years that culminated in the issuance of a ceaseand-desist order last year.

Director GILLERAN. I can appreciate your concern, Senator Sarbanes. I do think, however, that the bank regulators should be

given time to prove that they can regulate appropriately in this

area, because I think in order to be effective in this area, you must

understand bank procedures, bank controls, and bank systems.

Therefore, the bank regulators have the best staff to do that with.

I think it is not a question of our not having the staff to do it.

I think you are concerned about whether or not we have sufficient

emphasis on this important area and whether or not we are giving

it the correct amount of attention. I can tell you that, for the OTS,

I believe we are, but we have to prove ourselves in this area. And

36

therefore, I would ask that Congress give us more time to prove

that we can do this.

Chairman SHELBY. Do you have that time? Do we have the luxury of time?

Director GILLERAN. Well, I think that we have the best staff, I

think, that you can look to us to get this job done, because these

are people that know the financial institutions and know the systems and know what to look for. So you have the best people to

do it here.

Chairman SHELBY. I understand that, but do we have that luxury of time in our war against terrorist financing?

Director GILLERAN. If you were to change the regulatory structure and create a new agency, it would be creating a hiatus of time.

Chairman SHELBY. No one has suggested that, that I know

about.

Director GILLERAN. I think that is what this started from.

Senator SARBANES. Didn’t the Inspector General of Treasury

criticize the OTS last year for insufficient follow-up on Bank Secrecy Act problems?

Director GILLERAN. That was true, Senator, and I would say that

we appreciated that review so that it turned us to a problem that

I mentioned earlier, and that is the criticism that was made of us

was that we had given some smaller institutions more than one examination period to correct their problem. For instance, the Act requires an institution to have a sufficient training program, it requires the institution to have sign-offs. In no instance was there

any thrift that was involved in any money laundering, and that the

criticism was to procedural items.

Now, I agree with the GAO. They were criticisms. But the criticism was the fact that the thrift did not correct their lack of training or their lack of sign-offs within one examination period. We

have since addressed ourselves to that criticism.

Senator SARBANES. Mr. Chairman, I mean, we have all the regulators here and of course the agenda is a full scope of their responsibilities, I guess, with a particular focus on safety and soundness.

But I would suggest that we may want to do a hearing specifically

addressed to money laundering and the Bank Secrecy Act. We

could go through very carefully with each of them exactly what

they are doing and where they may have fallen down on the job

and what more needs to be done. This is an important area of activity, obviously, and if something happens, you can bet your life

it is going to be an important area of activity.

Chairman SHELBY. I think it is a good suggestion and we would

be properly prepared for it. Chairman Sarbanes wanted to comment.

Senator SARBANES. Chairman Greenspan.

Chairman SHELBY. Greenspan. I am saying Sarbanes. He was

the Chairman. I do not want him to be the Chairman in the future.

[Laughter.]

But he could be, you know. If he is, I will be respectful.

Chairman GREENSPAN. Mr. Chairman, I would just like to associate myself with some of the remarks of my colleagues. To be sure,

we do not have time. But bringing in a third party at this stage,

in my judgment, is not going to expedite this process. And the reaVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00040 Fmt 6633 Sfmt 6633 24910.TXT SBANK4 PsN: SBANK4
37

son, essentially, is that enforcing the Bank Secrecy Act invariably

requires that you, in the normal examination process, sense anomalies in the system, things that look just a bit off, things that do

not seem to square. And it is when you dig into those fissures in

the system that you come up with embezzlement, you come up with

money laundering, you come up with illegalities which the process

endeavored to hide. I do not think somebody coming in from the

outside can do it by some shortcut method. They have to go

through a whole examination process. I do not think you can separate examination of banks, under the Bank Secrecy Act, from the

overall examination process.

Chairman SHELBY. In other words, what you are saying, as I understand it, have the right mentality, culture to do the job, it is

just a question of adding this on to their work. Is that correct?

Chairman GREENSPAN. Exactly, yes.

Senator SCHUMER. Mr. Chairman.

Chairman SHELBY. Senator Schumer.

Senator SCHUMER. I have just one question here, really, directed

at Mr. Hawke. You said that you had a risk-based approach. In reference to the Chairman’s comment, Riggs Bank was high-risk because of its location. And yet, it is my understanding that there

were two checks on Riggs in relation to Bank Secrecy, one in 2000

and then one in 2003, and most of the bad stuff occurred between.

Is it that you are understaffed? I mean, why, with a particularly

high-risk bank, are we supposed to wait 3 years between examinations? Or am I wrong in the——

Comptroller HAWKE. I do not think that is right, Senator Schumer. Riggs was regularly examined by the OCC and, as I said,

over——

Senator SCHUMER. This was for Bank Secrecy Act violations.

Comptroller HAWKE. Over a period of 3 or 4 years, there was escalating concern about Bank Secrecy Act compliance issues at

Riggs. In retrospect, one could easily wish that we had been tougher earlier. But it was not that issues of Bank Secrecy Act compliance went unnoticed. It was that supervisory attention focused initially on internal control systems and training, and concern gradually escalated over that period of time.

Senator SCHUMER. If I am right—and maybe I am wrong, but if

I am right that there was one examination for Bank Secrecy in

2000 and then the next one was 2003 for a particularly high-risk

bank would you say that would not have been enough?

Comptroller HAWKE. It probably would not have been enough. I

do not think——

Senator SCHUMER. Could you check and get back in writing

about that?

Comptroller HAWKE. I would be happy to.

Senator SCHUMER. That would be great.

Chairman SHELBY. Mr. Hawke, did your examiners call in the

FBI or did the FBI call in your examiners? In other words, who got

into Riggs first? Was it FBI or was it your examiners examining

the bank because of possible violations of the Bank Secrecy Act?

Comptroller HAWKE. I cannot tell you definitively, Mr. Chairman.

Chairman SHELBY. Would you do that for the record?

Comptroller HAWKE. I would be happy to.

38

Chairman SHELBY. Okay, it is important.

I want to move to deposit insurance. Senator Johnson is not here

right now, but he made part of that his opening statement.

Last year, I asked each one of you to work with the Treasury to

develop a consensus deposit insurance reform proposal. I thought

that the proposal that was produced would provide meaningful,

comprehensive reform. Do you still support that proposal, Chairman Greenspan?

Chairman GREENSPAN. We do, Mr. Chairman.

Chairman SHELBY. Mr. Hawke.

Comptroller HAWKE. Yes, Mr. Chairman.

Chairman SHELBY. Mr. Powell.

Chairman POWELL. Yes, sir.

Chairman SHELBY. Mr. Gilleran.

Director GILLERAN. Yes, sir.

Chairman SHELBY. Mr. Dollar.

Mr. DOLLAR. Yes, sir. We seek parity with the other Federal insurance fund.

Chairman SHELBY. We have discussed many ways in which

banks have become smarter—you know, they have learned, grown

healthier and better able to operate in a safe and sound fashion.

Should we be mindful of creating inappropriate incentives and disincentives in deposit insurance reform legislation? In other words,

one of the statements around has been that if the reform package

passed, it would increase basic coverage as well as coverage for retirement accounts, to amounts such as $150,000 to $250,000.

Would banks lose some of their discipline here and management

skills, and slip back? I do not know. And especially all that bothers

me in view of the average savings account that is ensured across

the country. I do not know exactly what it is. I would bet you

would know. Is it less than $30,000?

Chairman POWELL. Yes, sir.

Chairman SHELBY. We are talking about running the rates up past $100,000—I am not, but others are. And then retirement accounts or whatever are even past that. And that is troubling to me.

Somebody sat on this Committee during the thrift debacle, the

former Chairman did.

Chairman POWELL. Mr. Chairman, a couple of comments. I was

in the industry, on the other side.

Chairman SHELBY. So you know.

Chairman POWELL. And oversaw an institution that almost

failed. A couple of comments. I cannot imagine a CEO of an institution who would take undue risks because coverage increased. Most

CEO’s have a vested interest in that institution in the form of ownership and reputation. It would be committing suicide——

Chairman SHELBY. But the insurance is really assuming part of

the risk, is it not?

Chairman POWELL. It is assuming part of the risk, but I can assure you if the institution fails, your net worth goes to zero.

Chairman SHELBY. I understand.

Chairman POWELL. And also you are subject to some other

issues. But our view at the FDIC has been clearly, from the very

beginning, that the coverage issue should be indexed. I would hope

that——

39

Senator SARBANES. Is that the position—the Chairman put a

question earlier about the proposal that was——

Chairman SHELBY. That was not in the proposal.

Senator SARBANES. And you all said you were for that proposal

and now you are telling us you differ on an important aspect of the

proposal.

Chairman SHELBY. We did not—as I recall, that did not call for

indexing, even retroactively or prospectively.

Chairman POWELL. I think it was silent on the coverage issue.

I could be wrong about that.

Chairman SHELBY. It was not silent at the table.

Chairman POWELL. Our issue has always been that it should be

indexed.

Chairman SHELBY. That is the FDIC you are speaking of.

Chairman POWELL. Yes, sir. I think it is unfortunate that this

particular part of deposit insurance reform gets an enormous—and

I am not saying it is not important, but it gets an enormous play

when other parts of deposit insurance reform, in my view, are more

critical to pass, that we can serve the industry, and that those components of deposit insurance reform be passed. I think it is past

time that we need to focus on those issues that Senator Johnson

and you have spoken about.

Chairman SHELBY. I know my time is running fast, but protection of the banking system generally. Chairman Greenspan, in your

opening statement you referred to the interagency whitepaper on

sound practices to strengthen the resilience of the U.S. financial

system. Mr. Hawke, you similarly referred to the issue of resilience

of the financial system, although within the context of Basel II. I

would like to focus my question briefly on the whitepaper to which

Chairman Greenspan referred.

It has now been a year since the final report was concluded and

2 years since the draft report was on the street and available for

industry comments. Sound practices outlined in the report set forth

certain goals for recovery and resumption of operations following a

major regional disaster. Specifically, business activities of core

clearing and settlement organizations, according to the recommendations of the Federal Reserve Board, the Office of the

Comptroller of the Currency, and the Securities and Exchange

Commission, should be resumed within the same business day as

the disruption, with the goal to resume operations within 2 hours.

While I understand this goal is consistent with pre-September 11

policy within the banking industry, I would be interested in hearing your views on the progress industry has made to date in meeting the key objectives of the whitepaper. Have the goals of the

whitepaper been taken to heart by the industry, and are the recommendations being implemented? Have the legitimate considerations of cost proven prohibitive to meeting these goals and, if so,

what measures, including incentives, would you recommend for facilitating progress?

That is not too much for any of you. I will start with Chairman

Greenspan.

Chairman GREENSPAN. I think you should start——

Chairman SHELBY. Okay, you defer to Mr. Hawke.

Chairman GREENSPAN. Go ahead. I will follow up on his remarks.

40

Chairman SHELBY. He handed you a good one, then. Go ahead.

Comptroller HAWKE. Well, I was waiting to hear what Chairman

Greenspan had to say.

The whitepaper set forth a number of expectations and time

frames for financial institutions with respect to clearing and settlement activities, recovery and resumption objectives, and other criteria, as well. With respect to progress at national banks, all of our

large national banks that are covered by the paper have either already satisfied those requirements or are making substantial

progress in meeting those goals. Our evaluation is that they are all

taking this effort very seriously and devoting substantial resources

to complying with the parameters that were set out in the

whitepaper.

Chairman SHELBY. Chairman Greenspan, do you agree with

that?

Chairman GREENSPAN. Yes, I do. I think we are fortunate in the

sense that the price of technology has been coming down fairly dramatically and it has enabled redundant systems to be developed

off-site in many different areas. And it is not only the individual

banks who are addressing this issue, but also those of us who were

involved in the payment systems, specifically the Federal Reserve

banks, have also been engaged in an extraordinarily intensive endeavor to make certain that we insulate our systems from various

different types of shocks. So far, we have, obviously, run into various different types of problems and they were handled well. We recovered remarkably well out of September 11 despite the fact that

there were numbers of weaknesses in the system. And we seem to

be gradually getting to the point where the flexibility and the resiliency of the system is increasing every month.

Now, whether that means we will be able to come back immediately from any shock, I do not know the answer to that. But

clearly, we are heavily involved in the payment system and the

major banks in the system, which are all acutely tied to this problem. I think we are making major progress. Will we ever get to the

point where we will say we are fully insulated? The answer is no,

we will not.

Chairman SHELBY. Sure.

Senator Schumer.

Senator SCHUMER. Thank you, Mr. Chairman. Just one brief

question. This bothers me, so I want to come back at it a little bit

with Chairman Greenspan. And that is, again, this deficit and how

it is going to affect the medium-term nature of the recovery—not

in the next 6 months, but in the next 18, or year or two.

I want to mention an editorial from April 15 Financial Times,

hardly a liberal mouthpiece or Democratic mouthpiece. They say,

But as the Bush Administration chooses not to hear, the problem

is not the short-term deficits run up now as a result of the global

economic slowdown, but those that respectable economists predict

will persist even when the U.S. economy has returned to full employment. The borrowing spree will push up real interest rates on

dollar assets, constraining investment and consumption such that

the net medium-term effect of the recent U.S. tax cuts on economic

growth will probably be negative.

41

Now, that seems to me to be—when I go around and talk to people on Wall Street and economists and experts, that is not the universal opinion, but I would say—it may not even be the majority

opinion, but it is the mode. You see more people saying that than

any other opinion. And it seems to me, that is what the markets

are feeling right now.

Should we be doing something about that now? Do we not have

to worry that interest rates will—you will be forced to raise interest rates too quickly and the longer-term recovery that we had in

the late 1990’s, because of fiscal responsibility, will be cut short?

Chairman GREENSPAN. Senator, I am concerned that we first put

into place a process which will enable us to address not so much

the short-term deficits, which I think are worrisome but the longerterm deposits. The short-term deposits pale against the problems

in the longer-term future. I think it is probably not very fruitful

to talk about programs or what we are going to do until we get a

budget process in place with PAYGO back in the structure of the

decisionmaking, and discretionary caps, which served us so well in

the earlier period.

Senator SCHUMER. Would you say those should be on the tax side

as well as on the spending side?

Chairman GREENSPAN. My view is that what we should reintroduce are the PAYGO and discretionary cap provisions which effectively expired in September 2002, which includes both spending

and taxes. And if we fall short on that, we are going to find that

we will not be able to maintain the degree of discipline which is

going to be necessary to address what is a very significant problem

out there.

Senator SCHUMER. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you, Mr. Chairman.

Mr. Powell, I want to ask you about payday lending. The OCC,

the OTS, and the Fed have all taken action to ensure that payday

lenders do not rent charters from the depository institutions which

they supervise. Why does the FDIC continue to allow banks that

it supervises to engage in payday lending practices when the other

regulatory agencies strongly discourage partnerships between payday lenders and Federal thrifts, national banks, and State-charter

members of the Federal Reserve? You are the only regulator who

is turning a blind eye—more than turning a blind eye, really, allowing this rent-a-charter practice to go on. Why are you doing

that?

Chairman POWELL. Senator, we supervise in excess of 6,000 institutions. There are 11 institutions that currently have arrangements with payday lenders. We have examined those institutions

on several occasions. We have issued guidelines for payday lenders

that are much more harsh as relates to capital allocation, to procedures and policies, to discrimination, to fairness, to anything that

might be illegal as it relates to the existing law. We have asked

one of those payday lenders to discontinue that activity.

Senator SARBANES. Yes, but the others do not think they should

be doing it at all. They are not allowing this rent-a-charter practice

to go on. The Center for Responsible Lending estimates that the

42

debt trap of payday lending, those borrowers who have five or more

payday loans per year, cost borrowers in excess of $3 billion a year.

Chairman POWELL. We have not——

Senator SARBANES. What are you doing about rollovers? What

are your rules on that?

Chairman POWELL. We have stringent guidelines as it relates to

rollovers. We look for violations of usury laws. We look for violations of any of the laws. And when we find those violations, we ask

them to stop.

Senator SARBANES. What is your rule on the number of payday

loans that can be made to the same borrower in a single year?

Chairman POWELL. I cannot answer that specifically——

Senator SARBANES. Do you have a rule?

Chairman POWELL. —but I will be happy to get to you——

Senator SARBANES. Do you have a rule on that issue?

Chairman POWELL. I cannot answer that. But payday lenders

are——

Chairman SHELBY. Excuse me, Mr. Chairman, could you furnish

that for the record and Senator Sarbanes?

Chairman POWELL. I would be happy to. Payday lenders are not

unique to the FDIC, in that under the shared national credits, payday lenders are part of shared national credits. They have—and we

participate in—shared national credits, together with OCC and the

Federal Reserve. And payday lenders are part of the shared national credits. So they are not unique as it relates specifically to

the FDIC.

Senator SARBANES. Of the 11 FDI-supervised banks partnering

with payday lenders, how many of them have you examined?

Chairman POWELL. All of them.

Senator SARBANES. All 11?

Chairman POWELL. Yes, sir.

Senator SARBANES. Do you examine them every year?

Chairman POWELL. Yes, sir.

Senator SARBANES. So each of those 11 has been examined within a year?

Chairman POWELL. I cannot specifically tell you that they have

been examined to the calendar year, to the point, but they are examined on a regularly scheduled basis as we would examine any

other institution.

I was just passed a note, Senator——

Senator SARBANES. Aside from the examining, what is the rationale for—all the other regulators do not think this practice should

take place. You are the only one at the table who thinks it should

go on. Now, what is your rationale to support your taking an oddman-out position on this important issue?

Chairman POWELL. I think that the rationale is that they are

meeting a need in the community that the marketplace has said is

there. And it is our job to make sure there is no safety and soundness issues and no violation of the law.

Senator SARBANES. Without any regard to the exploitation that

is taking place?

Chairman POWELL. Without any regard to——

Senator SARBANES. I mean, they are obviously coming in trying

to use the Federal charter in order to get around State laws which

43

control those practices. Is that not right, Mr. Lavender? Do you

know about this issue?

Mr. LAVENDER. I am familiar with the issue. And that is a concern that we have, that some institutions will——

Senator SARBANES. The States enact laws to guard their people

from these payday lending practices, and then they go rent a Federal charter under the supervision of Federal regulatory authorities

in order to get around those limitations. Is that not correct?

Mr. LAVENDER. In Tennessee, the payday lenders are a duly licensed entity that we regulate, that we can regulate.

Senator SARBANES. Okay, you do it a different way, then.

Mr. LAVENDER. Exactly, but——

Senator SARBANES. There are some States that prohibit them.

Mr. LAVENDER. We do have a concern that as banks continue to

express an interest in getting into that business that they will affiliate with some of our payday lenders and thereby avoid the State

regulation.

Senator SARBANES. Mr. Chairman, my time is running and I

want to ask one more question, if I might.

Chairman SHELBY. You may.

Chairman POWELL. Mr. Chairman, pardon me, I have not answered Mr. Sarbanes’s question.

Chairman SHELBY. Go ahead.

Chairman POWELL. Our guidelines requires a 60-day mandatory

charge-off for payday loans.

Senator SARBANES. I want to ask this question of the panel people. Since 1992, total assets in the banking system have doubled,

from $4.5 trillion to $9 trillion. Deposits have grown from $3.5 trillion to almost $6 trillion. Over that same period, the assets held

by the five largest institutions have increased more than fivefold,

and the deposits held have increased by 460 percent. The issue, I

guess, is better put if we say in 1992 the five largest banks had

12 percent of the total assets of the banking system; today they

have 32 percent. That is assuming these two mergers that are now

pending go through. Similarly, in 1992, the five largest banks had

11 percent of the total deposits of the banking system, while today

they have 31 percent. Does this level of consolidation and concentration cause any of you any concern?

Comptroller HAWKE. Mr. Chairman, Senator Sarbanes, let me

take a first crack at that. There are two aspects to the issue. One

is looking at it from a competitive point of view, in antitrust terms.

The other is looking at it in terms of the ability to supervise and

examine institutions of growing size.

On the competitive side, the numbers you are looking at reflect

nationwide concentration levels. While it is true that concentration

nationwide has increased, concentration in local markets has actually decreased over this period of time. I think Chairman Greenspan may have mentioned this earlier. We find that local markets,

which are critically important for consumers and small businesses,

are becoming less concentrated and more competitive, even as concentration on the national level is increasing.

From a safety and soundness point of view, there is no question

that mega-banks present challenges for supervision. We already supervise some very, very large banks, and we have full-time resident

44

teams of examiners in these banks with a variety of specialists who

are trained in particular aspects of the bank’s business, such as

capital markets, asset management, and the like.

The continued growth of mega-banks is certainly going to put a

high premium on the training of specialists and on interagency cooperation. We will have to work closely with our colleagues at the

Federal Reserve, as the holding company supervisor, and Chairman Powell has already mentioned the FDIC’s concern with large

banks, to make sure that we are taking a coordinated approach to

supervision of these large banks. There is no question that the increased concentration in the banking system does present supervisory challenges. I think we are up to those challenges.

Senator SARBANES. Anyone else?

Director GILLERAN. My own reaction, Senator, is that having

come from the smaller bank arena, having run one is San Francisco, I believe that a smaller institution has every capacity and capability of competing in the niches that it has selected for itself,

and that a strategy of going head-to-head as a small bank against

major banks and to compete on rates is not one that is successful

very often.

Therefore, there is definitely an arena to service America’s financial needs for small banks, and, therefore, small banks will always

be with us, as long as we permit them to be there. And on top of

that, they are very profitable.

So from the standpoint of the profitability of the investment, it

is a good investment; and from the standpoint of servicing the public, it is very good because you must search for niches that the bigger banks are not servicing.

I believe that the growth of the major banks is not something

that we should be afraid of. It is really the growth of the kind of

mass-produced services that credit cards represent and other types

of lending. But there is a niche out there for smaller banks that

will always be with us, and they are doing it very well.

Senator SARBANES. Well, I am trying to anticipate a trend. If the

consolidation were to continue at the same rate that it has been

taking place, and if the total amount of assets in the system were

to grow at the same rate, in 10 years’ time the top five banks

would control 65 percent of the total assets of the system.

Would that level of concentration be a matter of concern?

Mr. LAVENDER. Chairman Sarbanes, as a State regulator I am

concerned today about this level of concentration. I agree from a

competitive standpoint that our small community banks do an excellent job, another year of record profits. From a standpoint of

choice, while we continue to see a concentration, I do believe in free

market enterprise where let the free market reign. And, therefore,

citizens have to choose where they are going to do their banking.

But I would like to go to the point Comptroller Hawke mentioned, and that is supervision and examination. As a State regulator, I am concerned that my Federal counterparts have the capacity, the staff, the budget, to continue examination, the depth of examination of these entities as they continue to consolidate.

I hate to sound like a broken record today, but, again, looking

at the preemption and the inability of not only this department but

also Attorneys General to enforce consumer protection rights for

45

our consumers, I am concerned not only about the bank and the industry; but I am also concerned about the consumer as well. And

I do not have a comfort level today that with continued concentration the industry is positioned to supervise and examine adequately.

Senator SARBANES. Thank you very much.

Chairman SHELBY. Thank you, Senator Sarbanes.

I am going to go back to Chairman Sarbanes—not Chairman Sarbanes. I have it on my mind, haven’t I?

[Laughter.]

We have a roomful of people here and they are all chairmen.

China, Chairman Greenspan, I have been told they consumer 40

percent of the coal in the world, 25 percent of the scrap metal, and

a similar amount of precious ores and other metals, not counting

oil. I do not know how much oil and gas they are consuming, but

as they continue to grow industrially, they will consumer more.

Some people have said that because of China, not just because—

that they have put—they have driven the price of scrap metal and

other things up. I guess the question is: Will they absorb this because of their labor market, because there is no real pressure on

them in the labor market, 1.3 billion people, a lot of people looking

for work? Will they let their currency float within some kind of an

upward band? Or what do you predict? Or you do not. You see

what I am getting at?

Chairman GREENSPAN. Yes. First of all, let us recognize that

there has been a particular surge in the demand for metals which,

to a large extent, reflects the marginal demand coming from China

as it is endeavoring to move toward a market economy in some of

the older industries. The reason they are absorbing such a significant part of the steel scrap in the world and, indeed, iron ore and

coke and all of the basic ingredients, is that that industry has not

been growing all that rapidly around the world, and they are now

moving into a state of industrial advance which creates very heavy

demands for what we 50 and 100 years ago went through and others did as well.

I think they are adjusting to an early stage of an industrial dynamic which is going to rapidly change. They are moving and in

a very impressive way.

The major problem that they have is not the reflection so much

of the demand for commodities. It is that there is a concern increasing in China that they are overheating as a consequence of a

fairly rapid increase in the money supply, which has been going up

approximately 20 percent a year.

They do not have the flexibility that we do. They have got still

very significant proportions of their output produced by State-run

enterprises, which by their very nature are rigid. They recognize

this, and they are moving to try to find the appropriate balance.

And implicit in that there is clearly going to be greater flexibility

of their exchange rate, there is clearly going to be at some point,

hopefully sooner rather than later, a reduction if not the ultimate

removal of the capital controls that they impose on Chinese residents in the accumulation of foreign assets. But it is a very delicate

process because their banking system is not in robust shape.

46

So they are moving, as best as I can see, in the right direction

in endeavoring to contain this, and I think it is in everybody’s interest that China move forward but not move forward in a unbalanced way, which could create great difficulties for them. And if

they run into trouble, they will create significant problems for

Southeast Asian economies, for Japan, and indirectly for us.

Senator SARBANES. Mr. Chairman.

Chairman SHELBY. Go ahead.

Senator SARBANES. Mr. Chairman, is it the case that if they reset

the peg rather than going immediately toward flexible rates, that

that would avoid dangers to the banking system that are constantly put forth as a reason why they cannot move now or in the

near future to flexible rates? But they could reset the peg without

those problems, could they not?

Chairman GREENSPAN. They could, but they would have to be

careful where they set it, because if they set it with too small a

change from where we are today, the markets would quickly presume that there are going to be further adjustments and they will

get a very large increase in capital inflows, which will create even

a greater problem.

There is, I would agree, a peg level which probably prevents that

from occurring. I do not know where that is. I am not sure that

they do. But they are working toward some resolution of the type

you are suggestion, as best I can judge.

Chairman SHELBY. Chairman Greenspan, when you use the term

‘‘peg,’’ is that like trading within a certain band?

Chairman GREENSPAN. Well, ‘‘peg’’ usually means a very narrow

band, and the Chinese insist that they have a flexible exchange

rate. But it is flexible in a very, very narrow range.

Chairman SHELBY. Gentlemen, thank you very much for your

contribution. We look forward to a number of questions that we

will ask you for the record, but we are also waiting, Mr. Hawke

and Mr. Powell, both of you, for answers to some questions. Thank

you.

The hearing is adjourned.

[Whereupon, at 5:14 p.m., the hearing was adjourned.]

[Prepared statements and response to written questions supplied

for the record follow:]

47

PREPARED STATEMENT OF SENATOR WAYNE ALLARD

Thank you, Chairman Shelby for convening this hearing on the current condition

of the banking and credit union industry. I am pleased to have the opportunity to

hear from our banking and credit union regulators to hear about issues facing the

United States banking system both domestically and internationally. It has been

nearly 3 years since we have taken a look at the industry and many events have

occurred that could have greatly shaken the economic stability of this country . Yet,

the banking system remains strong and able to meet the demands of its customers.

The year 2003 saw net profits of over $100 billion for commercial banks and the

demand for household credit has remained strong. Additionally, the total volume of

problem assets in commercial banks has declined steadily, and sustained confidence

in the capital markets is evident through risk measures derived from prices of

stocks, debt securities, and credit default swaps. The significant decline in loan

losses and credit losses has signaled the industry’s responsiveness to the lending experiences of the 1980’s and 1990’s. Overall, the banking industry remains strong,

and that is credited to the good work of our Nation’s banking and credit union regulators.

In order to continue this pattern of success, it is imperative that we maintain a

disciplined examination of both the banking system and the modernization of our

entire financial system. I would like to thank the witnesses for appearing before the

Committee today. I look forward to your testimony.

—————

PREPARED STATEMENT OF SENATOR JIM BUNNING

Thank you Mr. Chairman for holding this hearing and I would like to thank all

of our witnesses for joining us today.

I believe holding these state of the banking industry hearings is a very fine and

necessary tradition of this Committee. It is very worthwhile to hold these hearings,

so during the good times, we are prepared for the bad times. I am very glad that

all three of the Chairman during my tenure on this Committee have embraced this

tradition.

For the most part, the state of the industry seems pretty healthy. There are

things we need to keep an eye on, but for the most part, the safety and soundness

of our institutions is not a concern. I personally have some concerns about small

banks, which are crucial to the financial health of Kentucky. There have been many

mergers and acquisitions of small banks. My small banks are also becoming more

and more concerned about the competing pressures they are facing. The small community banks are the only source of capital in many areas of my State, and it is

crucial that ensure their health and safety.

Once again deposit insurance is an issue we are facing. I fully support deposit insurance reform. However, I am very troubled by attempts to raise the insurance coverage limits. I have been Chairman Greenspan’s most vocal critic on monetary policy. But I agree with him wholeheartedly on raising insurance coverage. I believe

we agree so strongly about this, along with the Chairman and Ranking Member of

this Committee, because all of us had to deal with the S&L bailout in the late

1980’s. I think I can speak for all of us who were in the Congress at that time and

say that none of us wants to go through that again.

I am very interested to hear about your specific sectors of the industry, and if

there is anything that we as Members of this Committee can do to help financial

institutions grow and remain profitable with jeopardizing safety and soundness. All

of you are the experts of the your sector. You know your sector much better than

we do. I look forward to hearing your opinions.

Thank you again for holding this hearing Mr. Chairman and I thank all of our

witnesses for testifying today.

—————

PREPARED STATEMENT OF SENATOR MIKE CRAPO

I look forward to your testimony on the condition of the banking and credit union

industry. In addition, I am interested in what issues you believe should or should

not be considered in a regulatory relief package to improve the condition of the

banking and credit union industry. As you are all aware, the House recently passed

the Financial Services Regulatory Relief Act by a vote of 392 to 25.

48

A regulatory relief package should eliminate outdated, ineffective, or unduly burdensome regulations that are not justified by either the need to ensure safety and

soundness or to provide consumer protection.

Outdated laws and regulations only serve to squander scarce resources that could

otherwise be used to provide financial services demanded by customers. The banking industry estimates that it spends somewhere in the neighborhood of $25 billion

annually to comply with regulatory requirements imposed at the Federal and State

levels.

While finding a consensus on these issues may be difficult, I look forward to working with you and my colleagues on this Committee to begin the process of taking

up regulatory relief in the Banking Committee.

—————

PREPARED STATEMENT OF ALAN GREENSPAN

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

APRIL 20, 2004

Chairman Shelby, Senator Sarbanes, and Members of the Committee, I am

pleased to be here this morning to discuss the condition of the U.S. banking system

and various related matters. They include improved risk-management practices of

banks, the current status and direction of our regulatory efforts to revise capital

standards for internationally active banks, deposit insurance, and the ongoing consolidation process within our domestic banking industry.

Growth in the size and complexity of the largest U.S. and foreign banking organizations, in particular, has substantially affected financial markets and the supervisory and regulatory practices of the Federal Reserve and other bank regulatory

agencies around the world. It has, in part, required authorities to focus more than

before on the internal processes and controls of these institutions and on their ability to manage risk. Only through steady and continued progress in measuring and

understanding risk will our banking institutions remain vibrant, healthy, and competitive in meeting the growing financial demands of the Nation while keeping systemic risk at acceptable levels. Therefore, the regulatory authorities must provide

the industry with proper incentives to invest in risk-management systems that are

necessary to compete successfully in an increasingly competitive and efficient global

market.

When I last discussed the condition of the banking industry with this Committee

in June 2001, the industry’s asset quality had begun to decline, but from a relatively

high level, and banks were generally well-positioned to deal with the emerging problems. Moreover, as early as the late 1990’s, both the industry and bank supervisors

had begun to address the slippage in credit standards that was one of the causes

of the drop in asset quality. By most measures, this was an unusually early stage

in the economic cycle to begin addressing such deterioration.

Today, with the benefit of hindsight, we can see that the weaknesses I cited then

have indeed been mild for the banking system as a whole and that the system remains strong and well-positioned to meet customer needs for credit and other financial services. During the past 2 years, in particular, the industry extended its string

of high and often record quarterly earnings. For the full year 2003, commercial

banks reported net profits of more than $100 billion while maintaining historically

high equity and risk-based capital ratios and enjoying brisk asset growth. Although

the demand for business loans and the underwriting of equity securities have been

weak over the past few years, banking organizations have continued to benefit from

strong demand for household credit, not least for residential mortgage products as

interest rates declined substantially.

Moreover, the volume of problem assets in commercial banks declined each quarter last year, including a drop in the fourth quarter of nearly 10 percent, which

brought the ratio of problem assets to total loans and foreclosed assets to less than

1 percent—its lowest level since year-end 2000. As a result of this favorable performance, both the size and the number of bank failures in recent years have been

exceptionally small. Last year, for example, only two banks, with combined assets

of just $1.5 billion, failed.

The results of last year’s interagency review of large syndicated loans and internal reports about the level and distribution of their criticized and classified credits

lead us to expect still further improvement in the industry’s asset quality this year.

Notably, the pool of ‘‘special mention’’ credits that are weak but still performing

(and which tend to produce the more serious problem assets) has shrunk both in

the annual Shared National Credit review and in the quarterly bank reports.

49

Risk measures derived from prices of publicly traded bank securities—stocks, debt

securities, and credit default swaps—also signal that market participants are taking

an increasingly positive view of the future of banks. Indeed, these measures suggest

the lowest level of market concern about these companies that we have seen during

the 5 years in which we have tracked them.

The banking industry’s relatively benign experience with loan losses these past

few years may not be surprising given that the recession was mild by most measures. The experience is more notable, however, when one considers the broader

range of shocks and developments that have occurred during this period, including

the September 11 attacks, Argentina’s credit default, the continuing shift by large

and not-so-large firms in this country from bank to capital market financing, and

the concentration of recent economic pressures on specific industries and business

sectors. These events tended to reduce the overall quality of corporate loan portfolios

at banks and contributed significantly to banks’ efforts to improve their measurement and management of risks, especially after the substantial credit losses they

suffered in the late 1980’s and early 1990’s. These efforts, aided by the continued

trend toward industry consolidation, helped moderate previous concentrations of

credit exposures in bank portfolios and fueled greater use of new methods of hedging and managing risk.

At present, credit risk-management practices are perhaps least developed in

measuring risk associated with exposures related to construction projects and to the

financing of commercial real estate, which have grown rapidly, particularly among

regional and community banks. At all banks, such lending represented nearly 19

percent of all bank loans at year-end 2003—the highest level thus far recorded—

and accounted for essentially all the loan growth last year at banks with less than

$1 billion in assets.

Despite the limited development of formal risk-management practices, credit

standards applied to these loans have apparently been quite high. At least, we see

as yet no signs of rising credit losses from such lending, and supervisory and market

sources indicate that the poor lending practices of the late 1980’s and early 1990’s

have been largely avoided. Nonetheless, the historical record provides ample evidence of the risks associated with this form of lending and of accumulating large

credit concentrations in any form of exposure. Supervisors continue to monitor these

concentrations and the lending practices and market conditions that will ultimately

determine their effects on the banking system.

These and other gradual changes in the balance sheets of banks, along with the

sustained decline in market rates, helped compress net interest margins at many

banks, as they chose not to reflect the full effect of lower market rates into rates

paid on deposits without a specified maturity. As a percentage of earning assets, net

interest income of all insured commercial banks declined 27 basis points last year,

to 3.80 percent, the lowest level in more than a decade. Although this compression

eased slightly during the fourth quarter, we cannot yet tell whether margins have

begun to rebound.

This compression of margins needs to be understood in the fuller context of the

banks’ sensitivity to changes in interest rates and, in particular, the effect of historically low rates on banks’ financial performance and condition. At the same time that

declining rates were adversely affecting the industry’s interest margins, they were

also spurring growth in mortgage-related assets and associated loan-origination fees

and were producing significant capital gains in bank investment portfolios. Lower

interest rates, along with the decline in equity valuations experienced during 2000–

2002, also contributed to a substantial inflow of liquid deposits by lessening their

opportunity cost.

Under these circumstances, and with a steep yield curve, a banker’s natural inclination might be to shift the credit mix and extend the maturity of assets in an

attempt to bolster asset yields. To some extent such actions have been taken. Residential mortgage loans and pass-through securities have increased from 17.5 percent of assets in 2000 to 20 percent in 2003. But the manner in which this growth

has occurred suggests a balanced assessment of risk. Call Report data indicate that

a substantial portion of the increase in mortgage assets has been in adjustable-rate

or shorter-term mortgages, particularly at smaller banks. For their part, large institutions also have significant capacity to offset on-balance-sheet exposures through

off-balance-sheet transactions.

All told, the available data, industry and supervisory judgments, and the long and

successful experience of the U.S. commercial banking system in dealing with changing rates suggest that, in general, the industry is adequately managing its interest

rate exposure. Many banks indicate that they now either are interest-rate neutral

or are positioned to benefit from rising rates. These views are based partly on specific steps that they have taken to adjust portfolios and partly on judgments about

50

the effects that rising interest rates would have in easing pressure on interest margins. That is, many banks seem to believe that as rates rise—presumably along with

greater economic growth—they can increase lending rates more than they will need

to increase rates paid on deposits. Certainly, there are always outliers, and some

banks would undoubtedly be hurt by rising rates. However, the industry appears

to have been sufficiently mindful of interest rate cycles and not to have exposed

itself to undue risk.

In other areas, earlier concerns about the effect of the century date change on

computer systems, the destruction of infrastructure in the September 11 attacks,

and the increased volume and scope of banking transactions generally have also required financial institutions, particularly large institutions, to devote more effort

and resources to contingency planning in order to ensure the continuity of their operations. Last fall’s power outage and Hurricane Isabel may have offered only limited tests of the industry’s improved procedures, but financial firms handled those

challenges extremely well.

As the Nation’s central bank and as a bank supervisor, the Federal Reserve has

a strong interest in the continued operation of the U.S. financial system after a disruptive event. To that point, last year, the Federal Reserve Board, the Securities

and Exchange Commission, and the Office of the Comptroller of the Currency jointly

issued an interagency paper, ‘‘Sound Practices to Strengthen the Resilience of the

U.S. Financial System.’’ That paper provides guidance that supplements long-standing principles of business continuity planning and disaster recovery and is directed

at the entities that pose systemic risk to the financial system, particularly in the

context of their clearing and settlement activities. Through the Federal Financial

Institutions Examination Council, we also issued revised examination guidance on

business continuity planning. This guidance covers a variety of threats to business

operations, including terrorism, and will be used in future examinations.

Improved Risk Management in Banks

Independent of continuity planning for unusual events, the basic thrust of recent

efforts to improve the management of risk has been better quantification and the

creation of a formal and more-disciplined process for recognizing, pricing, and managing risk of all types. In the area of credit risk, by providing those involved with

a stronger, more-informed basis for making judgments, this development has

enhanced the interaction between lending and risk-control officers. Operating with

better information does not mean that banks will necessarily reduce credit availability for riskier borrowers. It does mean that banks can more knowingly choose

their risk profiles and price risk accordingly. Better, more-informed lending practices should also lead to a more-efficient allocation of scarce financial capital to the

benefit of the economy at large.

Greater internal transparency and quantification of risk have helped bank managers monitor portfolio performance and identify aspects of the risk-measurement

and credit-granting process that begin to move off track. As risk-measurement and

disclosure practices evolve, investors and uninsured creditors will also become more

motivated and better positioned to understand the risk profile of banks and convey

their own views of banking risks. Indeed, accommodating greater and moreinformed

market discipline is an important goal of bank supervisors.

Perhaps most important, better risk management has already begun to show real

potential for reducing the wide swings in bank credit availability that historically

have been associated with the economic cycle. Sound procedures for risk quantification generally lead to tighter controls and assigned responsibilities and to less unintended acceptance of risk during both the strengthening and weakening phases of

the business cycle. Earlier detection of deviations from expectations leads to earlier

corrective actions by bank managers and, as necessary, by bank supervisors.

Better methods for measuring credit risk have also spurred growth in secondary

markets for weak or problem assets, which have provided banks with a firmer,

sounder basis for valuing these credits and an outlet for selling them and limiting

future loss. Insurance companies, hedge funds, and other investors acquire these assets at discounts that they judge are sufficient to meet their expected returns and

balance their portfolio risks. The result is greater liquidity for this segment of bank

loan portfolios and the earlier removal of weakening credits from bank balance

sheets. Portfolio risks have also been increasingly hedged by transactions that do

not require asset sales, such as derivatives that transfer credit risk.

With greater use, more-thorough review, and more-extensive historical data, risk

modeling has improved in accuracy and will continue to do so. Supervisors are also

learning these techniques and are pressing banks to improve their own methods and

systems to keep up with the latest developments. In the United States, our leading

banking organizations began the process years ago and, in many respects, were in

51

the vanguard of the effort worldwide. Nevertheless, they and the risk-measurement

process itself have much further to go.

Recent initiatives of the Basel Committee on Banking Supervision to revise international capital standards have helped focus attention on risk-measurement practices and have encouraged further investment in this area. Moreover, the very

improvements in technology that facilitated better bank risk measurement and

management have undermined the current regulatory capital regime by creating

transactions and instruments that were not conceived when the current regulatory

standard was developed.

Although these developments have sometimes helped banks circumvent existing

rules, they have also enabled banks to hedge portfolio risk in ways that the current

accord does not address well. As a result, the current regulatory capital standard

is increasingly unable to establish capital requirements for our largest and mostcomplex banking organizations that reflect their true underlying risks. We need a

more accurate, more risk-sensitive measure of capital adequacy to provide these institutions with appropriate risk-management incentives and to provide ourselves

with a more reliable basis for supervising them in a way that focuses on true risks.

In the process, such a measure should also enhance our efforts in taking prompt

corrective action. For all these reasons, I believe the U.S. banking agencies must

remain committed to the process of developing and applying a revised regulatory

capital standard for the world’s international banks.

Proposed Capital Standards

Last summer, the U.S. banking agencies took another step toward adopting the

new capital standard by issuing for public comment an advance notice of proposed

rulemaking (ANPR). The conception and design of the proposed standard, referred

to as Basel II, are based on techniques developed in recent years by the largest

banks, especially those, as I noted, in this country. As the scale and complexity of

their activities grew, the banks needed to find better and more efficient ways to understand, manage, and control their risk-taking activities; to promote and respond

to the emergence of new markets, such as those for securitized assets; and to make

greater use of available technology and financial theory in measuring and managing

their risks.

Before the agencies issued the ANPR, numerous changes in the proposed Basel

II Accord had already been made in light of earlier comments. Reflecting the comments received on the ANPR, the Basel Committee agreed to extend the period for

reaching an agreement in principle until mid-2004 to permit more time for revisions

of the proposal to be formulated. Indeed, we have already negotiated some major

changes in the international proposal to reflect U.S. public comments. These

changes include the adoption of a framework based on unexpected loss and a revised

set of rules on securitization. We have also modified the implementation process to

ease the burden on banking organizations that operate across borders. These technical changes were high on the list of modifications suggested by commenters.

The shift from a combined ‘‘expected’’ and ‘‘unexpected’’ loss framework to one

that focuses on unexpected loss only is crucial to ensuring that the regulatory capital framework is consistent with standard internal banking practices, both here and

abroad. That change will also simplify other parts of the proposal. The modification

on securitization was imperative to permit U.S. banks to continue participating in

important funding markets that they pioneered and to ensure a prudent risk-sensitive capital treatment for securitization exposures. Beyond these achievements,

working groups in Basel are considering other U.S. proposals related to refining

measures of expected loss, an issue that a number of commenters raised. The U.S.

agencies are still trying to reach a consensus on a revised proposal for capital

charges on retail credit to put before our colleagues in Basel. The Federal Reserve,

for its part, will continue to make every effort to reach consensus on this issue that

is both risk-sensitive and workable.

I believe that all the Federal banking agencies are committed to achieving a revised accord that reflects the realities of the 21st century; that meets our needs for

a safe, sound, and competitive banking system; and that addresses the legitimate

concerns of the industry. The Federal Deposit Insurance Corporation has raised important issues about capital adequacy, and the Office of the Comptroller of the Currency has expressed significant concerns about a capital structure that may inadvertently disrupt retail credit operations of banks. All the agencies are addressing

these concerns by jointly developing proposals to bring to Basel. In working to reach

full agreement among ourselves, and ultimately with our colleagues abroad, we all

seek a solution that promotes sound banking practices and that we can adequately

implement and enforce. I hope that in the days ahead the agencies can close the

gap on credit cards within such an overarching framework.

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If we can do so, the Basel Committee should be able to reach agreement in principle on a new proposal around mid-year, and the U.S. banking agencies expect to

evaluate that proposal through another ‘‘quantitative impact study’’ that we plan to

conduct at large U.S. banks this fall. Committee Members are aware that this survey and public comments on a forthcoming Notice of Proposed Rulemaking may

raise still further issues that will need to be addressed before we can implement

Basel II in the United States. Of course, other countries have their own national

and European Union-wide review processes to conclude, and those consultations too,

may raise issues that will require additional attention.

As this Committee knows, the U.S. agencies have proposed that in this country

the most-advanced version of Basel II is to be required only of the largest, mostcomplex banking organizations, although we anticipate that some of the other larger

banks also will choose to adopt that version. Non-adopters in the United States will

continue to operate under the current capital rules. The current regulatory capital

regime, as I noted, has become less effective for the largest organizations while consolidation has sharply increased the scale and scope of their activities. In this country, the Basel II proposal focuses on them. The current rules remain appropriate

and prudent for other banking organizations in the United States, and the agencies

have decided that imposing the cost of new rules on these banking organizations

does not pass a cost-benefit test.

Nonetheless, change in the procedures for calculating regulatory capital for larger

banks creates uncertainty among those entities to which the new rules would not

apply. The comments we received on the ANPR and from the Congress last year

indicate that some smaller banks are concerned that their competitive environment

will change. More specifically, these fears include the possibility that Basel II will

induce adopters, who are likely to have reductions in regulatory capital requirements, to redeploy their capital by acquiring nonadopters or to gain a competitive

advantage, particularly in the markets for small business and residential mortgage

loans.

To judge the merits of these concerns, the Federal Reserve conducted two technical and empirical analyses of the underlying issues and made the papers available

to the public last month; Congressional staff members were also briefed. A third

study will be completed shortly, and a fourth will commence soon.

The first of these papers, dealing with mergers and acquisitions, found virtually

no statistical support for the view that either the level of, or changes in, excess regulatory capital have played a role in past merger and acquisition decisions, which

suggests that any future effect of Basel II on such decisions is also likely to be quite

small. Moreover, reductions in regulatory capital requirements for adopters relative

to the requirements for nonadopters are unlikely to lead to an acceleration in the

pace of consolidation.

The second study evaluated the likely effect of Basel II on the competition between adopters and nonadopters in the market for small- and medium-sized business loans. It estimated that the marginal cost of such loans at adopting banks

would decline no more than about 16 basis points, on average, and is likely to decline by less than that in most cases.

Importantly, the study also found that most small business loans made by community banks are sufficiently different from those made by either required or likely

adopters of Basel II as to make any marginal cost differences virtually irrelevant.

Moreover, being riskier, the small business loans made by most community banks

are priced so much above the loans made by the large banks that the marginal cost

benefit to adopters would not be a material competitive factor. The study did find,

however, that the types of small- and medium-sized business loans made by adopters and other large banks are, indeed, similar and similarly priced, so that adopting

institutions may have a competitive advantage in many cases over other large banks

that choose not to adopt Basel II. I will return to the implication of this finding in

a moment.

A paper analyzing competitive effects in the residential mortgage market will be

available later this spring, and once the U.S. agencies agree on a proposal regarding

the treatment of credit cards, staff members can begin analyzing potential competitive effects of the proposal in that market, as well. All four papers will then be reevaluated early next year when new data become available from the agencies’ next

quantitative impact study.

If the evidence following these reviews and a public comment process suggests

that implementation of bifurcated capital standards in this country may affect competition in certain markets, the proposals for Basel II may need to be reconsidered.

We may need, for example, to modify the application of Basel II in the United

States, where permissible under the Basel agreement; negotiate further changes in

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the international agreement itself; or change the way the current capital rules are

applied to institutions that do not adopt the new standard.

In short, if we have sufficient indications that implementation of a new capital

standard will distort the balance of competition, we can and will apply policies to

mitigate this effect consistent with the risk profile of individual institutions. We

cannot, however, respond to an unsubstantiated and generalized fear of change.

Such concerns should not halt the evolution of regulatory capital standards for the

large, complex banking organizations that play such an important role in our banking system and in global financial markets.

Bank Consolidation

Legislation designed to deregulate U.S. banking markets, technology, and other

factors have contributed to significant structural change in the banking industry

and to a decline of nearly 40 percent in the number of banking organizations since

the mid-1980’s, when industry consolidation began. Consolidation activity has

slowed sharply in the past 5 years, but a recent uptick in merger announcements,

including a couple of very large transactions, may signal a return to a more rapid

pace of bank merger activity. Since 1995, the 10 largest U.S. banking organizations

have increased their share of domestic banking assets from 29 percent to 46 percent

at year-end 2003. Yet, over the past decade, roughly 90 percent of bank mergers

have involved a target with less than $1 billion in assets, and three-quarters have

involved an acquiree with assets of less than $250 million.

This ongoing consolidation of the U.S. banking system has not, in my judgment,

harmed the overall competitiveness of our banking and financial markets. Although

they have facilitated consolidation, the reduced barriers to entry—such as were provided by the Riegle-Neal Act’s relaxation of interstate banking laws—have provided

net competitive benefits to U.S. consumers of financial services.

Other economic forces, such as technological change and globalization, have stimulated competition among depository institutions and between depositories and

nonbank providers of financial services. In addition to other credit-extending businesses, our system of depository institutions alone continues to be characterized by

many thousands of commercial banks, savings institutions, and credit unions. Measures of concentration in local banking markets, both urban and rural, have actually

declined modestly not just since 2000 but since the mid-1990’s. Significantly, most

households and small and medium-sized businesses obtain the vast majority of their

banking services in such local markets.

Deposit Insurance

I would like to turn now to the issue of deposit insurance reform and to the need

for some legislative change in this area. As the Committee knows, most depository

institutions have not paid any deposit insurance premiums since 1996, and in fact,

some large institutions that have been chartered in the past 8 years have never paid

them at all. Under current conditions, not only is a Government guarantee being

provided free, but also depositories having similar or identical risks are exposed to

potentially disparate treatment should one, but not the other, of the deposit insurance funds fall below its funding target. In that situation, the FDIC would be required to impose a charge on one set of depository institutions while continuing to

provide free deposit insurance to those in the other fund. Because some depository

institutions today have commingled BIF- and SAIF-insured deposits as a result of

bank and thrift mergers, this disparate treatment could apply even to different deposit accounts within the same depository institution.

At this time, the Congress has the opportunity to provide the FDIC with greater

flexibility to charge risk-based premiums, possibly using market data (for example,

rates on uninsured deposits) for the largest banks, to allow such premiums to increase or decrease in a gradual manner over a wider range of fund reserve ratios,

and to treat all depositories with similar risk ratings equally and equitably. Such

reforms should be implemented in a manner that does not unnecessarily create additional moral hazard and that strengthens, rather than erodes, market discipline.

Higher coverage limits, for example, would exacerbate moral hazard problems

without apparent and offsetting benefits. The current level of coverage seems adequate to meet the needs of an overwhelming majority of depositors. First, depositors

have certain flexibility in distributing large balances among multiple accounts and

depository institutions to obtain higher insurance coverage. Second, the Federal Reserve’s latest survey of consumer finances indicates that at year-end 2001 less than

4 percent of U.S. depositor households had any uninsured deposits. Moreover, the

median bank IRA/Keogh account balance was only $15,000, well below the existing

insurance limit. Finally, community banks have shown themselves just as adept as

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the largest banks in attracting uninsured deposits when necessary to fund customer

loan demand.

Conclusion

In closing, let me reiterate that the past decade has been one in which the banking industry has recorded persistent record profits while providing an ever-wider

range of products and services to much more diverse groups. The industry’s experience during the past several years in dealing with clear weakness in key economic

sectors demonstrates the importance of strong capital positions and sound risk-management practices. Bank supervisors worldwide are working to encourage further

progress in these areas, through more-accurate and more-effective regulatory capital

standards based on even better internal risk-management procedures.

—————

PREPARED STATEMENT OF JOHN D. HAWKE, JR.

COMPTROLLER OF THE CURRENCY, U.S. DEPARTMENT OF THE TREASURY

APRIL 20, 2004

Introduction

Chairman Shelby, Senator Sarbanes, and Members of the Committee, I appreciate

this opportunity to review the condition of the national banking system. My written

statement covers two principal areas.

First is the continued strong performance and condition of the national banking

system in the face of a changing banking environment. National banks continue to

display strong earnings, improving credit quality following the recent recession, and

sound capital positions. That continued strong performance reflects, in general, past

good lending and investment decisions. In addition, to some extent, that performance reflects changes in business strategies and risk management practices. Banks

have adopted better risk management techniques and have benefited from greater

geographic diversification. Nonetheless, risks remain, including the growing importance of operating, strategic, and reputation risk as banking companies adapt to

change by using technology, different products or strategies, or more complicated

business structures.

Second, we continue to adapt supervision to the changes in banking. Among the

most important strategies we employ to maximize the effectiveness of our examination and supervision program is our risk-focused approach to supervision, which is

designed to address change. That risk-based approach has enabled us to turn increasing attention to operating, strategic, and reputation risk.

The approach that the U.S bank regulators have taken to the effort to reform

international bank capital standards, known as Basel II, provides a distinct example

of how we are adapting to change. While we recognize that we can improve capital

regulation to take into account changes in banking and risk management, we have

advocated proceeding with appropriate caution. In my statement today, I will discuss the proposed capital reform and the commitment I have made that any reforms

of the regulatory capital rules will be adopted in a prudent, deliberate fashion.

The Condition of the National Banking System

The OCC supervises federally chartered national banks and federally licensed

branches of foreign banks. As of year-end 2003, the national banking system consisted of approximately 2,100 banks (26 percent of all commercial banks). Of these,

2001 were FDIC-insured banks, holding total assets of $4.3 trillion. The rest were

uninsured bank and trust companies. The OCC also supervises 53 Federal branches

of foreign banks. While the number of national banks has declined for nearly two

decades, and the assets of the system have steadily increased over the same period,

the national bank share of total system assets has remained roughly constant, and

now stands at 56.5 percent. The national banking system includes many of the largest banks by asset size, but community national banks are by far the most numerous in the system.

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Financial Performance

The financial performance and condition of the banking system is strong. Earnings have remained at historically high levels for a decade. Until 2002, aggregate

net income for national banks had never exceeded $12.5 billion in a quarter, and

the industry’s average return on assets had never exceeded 11.5 percent, at least

not since the quarterly reporting began in 1984. But since the beginning of 2002,

national banks have exceeded both earnings milestones in every quarter but one.

In 2003, national banks set new records for both return on equity and return on

assets. Although the slow economy led to weakness in some areas, including business lending, the contractions in these areas were more than offset by growth elsewhere.

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Total loans held by banks continued to expand throughout the recent economic

cycle, growing by 7.8 percent in 2002 and 7.6 percent in 2003. In contrast, starting

with the recession of 1990–1991, total loans held by national banks fell for 10 consecutive quarters. Where the earlier recession affected all sectors of the economy,

the recent recession was concentrated more extensively in the business sector, in

part due to the fallout from the tech/telecomm bubble in the late 1990’s. This caused

a sharp fall in the demand for business loans, particularly at large banks.

The reduction in corporate lending by banks also was due to the competitiveness

of corporate bond issuance due to low interest rates. Many large and even mediumsize firms have been able to access the bond market at very low rates throughout

this economic slowdown, which has further reduced the demand for larger commercial loans. This has affected especially the lending activity at the largest banks, because they tend to have potential business customers who have greater access to

other financial options. Community banks, in contrast, taking advantage of their

knowledge of local markets and business needs, have maintained their business

lending throughout this cycle, with increases reported in their commercial and industrial (C&I) and commercial real estate loan books.

The mortgage and consumer sectors have been a strong source of loan growth for

national banks. Residential real estate loans held by national banks rose at an annual rate of about 20 percent in both 2002 and 2003. Within this broad category,

home equity lending has grown particularly fast, rising by 21 percent in 2001, 38

percent in 2002, and 37 percent in 2003. Throughout this cycle, consumers have

taken advantage of declining mortgage rates to extract funds from the increased

value of their homes. Some of these funds from the refinancing and home equity

loan activity have been used, however, to pay off higher interest credit card and installment debt.

The low interest rate environment has been a plus and minus for banks. Smaller

banks with their greater reliance on retail funding have seen steady erosion in their

net interest margins. By contrast, the largest banks, which rely more on wholesale

funding, until recently experienced relatively high net interest margins. As of December 2003, the net interest margin for banks in all asset size groups has fallen

below their historic averages. Despite the decline in margins, banks have reported

continued growth in net interest income due to the strong expansion in household

lending. As long as margins remain compressed, however, this growth in income is

vulnerable if the volume of activity in the consumer markets falls.

The low interest rate environment also raises concerns about the extent to which

banks may be taking on interest rate risk in an effort to maintain their interest income. Effective management of this risk will be important for banks in all asset size

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groups as the economy recovers, which is often accompanied by an increase in interest rates. We have alerted national banks to our concerns on this score and provided

advice on approaches on how best to address this ‘‘low rate set-up.’’

Deposits have continued to flow into banks, especially large banks, as might be

expected when low interest rates hold down returns on alternative money market

instruments. Deposits at national banks grew at 6.0 percent in 2001, 7.6 percent

in 2002, and 8.6 percent (year-over-year) in 2003. The increase in deposits has

fueled growth in bank assets. The assets of national banks grew 9.8 percent in 2003

(year-over-year), as compared to a 0.1 percent decline reported at this point of the

recovery from the last recession. Nevertheless, we believe banks must be vigilant

in their assessment of the potential sensitivity of their sources of funds to changes

in the economic environment or, in some cases, the bank’s own performance. The

high level of liquidity in the banking system could be reduced rapidly if the relative

yield on alternative investments increased sharply or if banks failed to maintain

certain performance levels required to retain some sources of funds.

While credit quality deterioration is typically an issue during recessions, the most

recent experience for national banks was much better than during the previous recession. This may well reflect national banks’ response to cautions issued by the

OCC to bankers in the late 1990’s to be vigilant about their underwriting standards.

The noncurrent loan ratio for national banks (loans at least 190-days past due plus

nonaccruals) reached a peak of 4.4 percent in 1991Q2; in contrast, at the peak in

this economic cycle, reported in 2002Q2, the noncurrent ratio was 1.6 percent. For

large banks (over $1 billion in assets), the noncurrent loan ratio has now declined

to 1.3 percent, near prerecession levels. Smaller banks (under $1 billion in assets)

were not as affected by the stresses in the nonfinancial corporate markets and thus

experienced only a modest decline in credit quality during the recession. And while

credit quality appears to be improving for the banking industry, the OCC continues

to watch developments in areas that remain vulnerable, such as small business

lending and certain real estate markets and property types.

The data on bank failures and new entrants to the commercial banking system

also reflects a dynamic and healthy banking system. In 2003, two banks failed—one

national and one State bank. By contrast, 100 commercial banks—including 33 national banks and 67 state banks—failed in 1992, the first year of recovery after the

1990–1991 recession. The commercial banking system also had 111 new entrants in

2003; this compares to 40 new banks in 1992.

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While the national banking system has displayed strong performance, even during

the recent recession, history teaches us that we cannot know for certain what lies

ahead, and banks’ capital provides important protection against that uncertainty.

National banks remain well-capitalized and rest on a much firmer capital base than

they did more than a decade ago. In 1990, for example, 6.3 percent of banks had

risk-based capital ratios below 8 percent, which we would now consider undercapitalized, and 18.3 percent were below 10 percent. Today, all national wholesale

banks, with the exception of a few small banks under special supervision, have riskbased capital ratios above 8 percent, and more than 90 percent of national banks

have risk-based capital ratios above 10 percent.

Continued, Gradual Change in Bank Strategies

Like other businesses, banks adjust their strategies in response to the lasting

changes in their business environments. Over past decades, bank business strategies in the United States have evolved in response to changes in household financial

practices, advances in financial knowledge and information and communication

technology, and the relaxation of constraints against interstate banking and allowable bank activities. Since such changes are gradual, they are sometimes hard to

recognize. Nonetheless, they result in real changes in the nature of the business.

For example, one change is an increase in the relative emphasis on lending to

households, especially among the large banks. Over the last 20 years, large banks

have moved increasingly into retail lending to take advantage of cost-saving technologies and geographic diversification in a period of strong growth in the demand

for retail products. In 1984, 30 percent of aggregate commercial bank loans were

to households—residential mortgages, and loans to individuals. By 2003, that ratio

had risen to 46 percent. The increased emphasis on retail lending has been particularly pronounced in the largest banks. Among the largest 10 banks, the retail portion of bank loan portfolios has increased from 22 percent to 55 percent over the

last two decades.

Another strategic change in banking is the improvement in financial risk management—the tools, products, and processes. Since the last business cycle, banks have

made substantial investments in this area. A fundamental shift in approach is occurring, from viewing risk on a transaction-by-transaction basis to a more holistic,

portfolio view. Advances in technology have enabled banks to harness information

to manage more proactively the risks in their portfolios. These include more sophisVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00062 Fmt 6633 Sfmt 6621 24910.TXT SBANK4 PsN: SBANK4
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ticated models to help banks underwrite and manage their credit risks and to conduct scenario analyses of their interest rate and liquidity risks.

Concurrent with the adoption of these enhanced tools has been the development

of independent risk management units with responsibility for enterprise-wide risks.

These units, which typically reside at the highest level of the corporation, oversee

portfolio risk, balance the risks and rewards of new business strategies and initiatives, and ensure that business units and the bank as a whole comply with established risk tolerances and limits.

Risk management also has benefited from the broader array of products and tools

that banks can use to adjust and manage their risk profiles. These tools help to foster deeper and broader financial markets and ultimately help to allocate risks to

participants in accordance with their risk appetite and performance objectives. For

example, banks have been particularly successful in reducing their exposures to

credit concentrations. The growth of the syndicated loan market has enabled banks

to more broadly distribute credit exposures within the U.S. banking system, as well

as to foreign banking organizations and nonbanks. Similarly, the expanding asset

securitization market has provided banks with another avenue to manage concentration risks and to diversify their funding sources and to provide greater access

to underserved markets.

The growth in the derivatives markets has provided banks with additional tools

to manage their credit and interest rate risk exposures. Derivatives are also a valuable risk management product to help banks’ institutional customers manage a

broad array of risks arising from common business activities such as securing longterm funding or protecting the value of importing or exporting commercial goods.

Banks’ increased participation in residential real estate lending is one example of

how derivatives have enabled banks to expand their product offerings while managing their risk profiles. Although residential real estate lending is typically associated with low credit risk as a consequence of diversification, solid collateral, and the

borrower’s vested interest, it can represent high exposure to interest rate risk. With

the advent of products to hedge interest rate risk, such as interest rate swaps and

options, banks have been able to expand their lending in this area while managing

the risk of potential shifts in interest rates. In the absence of effective mechanisms

to hedge such risks, it is unlikely banks would have been able to participate as actively in the growth of this sector.

Growing Importance of Operating, Strategic, and Reputation Risk

Notwithstanding the strong financial performance and condition of the banking

industry, and improvements in the management of key financial risks, critical challenges remain. Chief among these is the need for banks to avoid missteps, abuses,

or perceptions that could undermine the confidence and trust of their customers or

financial markets. Recent events have demonstrated that bank soundness is much

more than just a function of financial strength and that the risks facing the banking

industry extend beyond the financial risks—credit, liquidity, and interest rate

risks—that have traditionally been the focus of bankers and regulators. Increasingly, bankers must be cognizant of and control the operational, strategic, and reputation risks posed by their activities and how their activities will be perceived by

the markets and their customers. A thorough evaluation of those risks and their potential impact on a bank’s longer-term strategic direction and its relations with its

customers is paramount and must override pressures from management, analysts,

or shareholders to increase short-term earnings at the expense of fundamental controls and safeguards.

Many of the recently publicized problems facing the industry have stemmed from

breakdowns in key governance and control areas: Insufficient oversight and due diligence in reviewing or considering complex financial transactions or new product

lines; lapses in security controls and the safeguarding of customer information; overreliance on third parties for critical services or product generation; and failure to

adhere to sound internal audit and control procedures and processes. These breakdowns are not limited to banks of a specific size, market or product niche. Community banks have suffered losses stemming from over-reliance on loans, investments,

and services purchased from third-party vendors—often in an effort to augment otherwise lackluster loan demand. Several large banks have faced significant questions

about their dealing with customers and alleged improper oversight and management

of key product lines.

Keeping Pace with Change in the National Banking System

Change is a consistent theme in the operation—and the supervision—of the national banking system today. National banks must evolve their businesses if they

are to remain competitive in today’s financial services markets. At the same time,

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the OCC must adjust its supervisory and regulatory approaches in order to ensure

that national banks can avail themselves of all of the attributes of their charter

safely and soundly. Among the most important strategies we have developed to

maximize the effectiveness of our examination and supervisory program is our riskfocused approach to supervision.

The OCC’s Risk-Focused Approach to National Bank Supervision

OCC’s supervision by risk approach dates back more than 10 years and involves

supervisory policies and processes that tailor our oversight to the key characteristics

of each bank, including asset size, products offered, markets in which it competes,

and the board’s and management’s tolerance for risk. This process provides an effective means for the OCC to allocate our supervisory resources and to better communicate to senior bank management the areas where they may need to correct

problems before they become entrenched.

Risk-based supervision begins with an assessment of a banking organization’s existing and emerging risks, and management’s efforts to manage and control those

risks, in nine specified risk areas: Credit, liquidity, interest rate, price, foreign exchange, transaction, compliance, strategic, and reputation. Based on that assessment, the OCC examiner-in-charge or portfolio manager will develop and implement

a detailed, supervisory strategy for the bank, based on its risk profile and the complexity of its lines of businesses. Examiners identify areas of highest risk, assess

what management is doing to address those risks, and communicate regularly with

management to indicate where additional management actions are needed. In performing this evaluation, OCC examiners consider not only the activities of the bank

and its operating subsidiaries, but also how the bank’s risk profile is affected by the

activities of other subsidiaries and affiliates.

Our assessment of the integrity and effectiveness of a bank’s risk management

systems includes appropriate validation through transaction testing. If this produces

concerns, we will ‘‘drill down’’ to test additional transactions. And if this reveals

problems, we have a variety of tools with which to respond, ranging from informal

supervisory actions directing corrective measures, to formal enforcement actions, to

referrals to other regulators or law enforcement. The examination procedures implementing OCC’s supervision by risk program are documented in the Comptroller’s

Handbook.

Supervision by risk provides an effective way to supervise banks in the current

rapidly changing environment. It also allows us to apply a consistent supervisory

methodology across an increasingly diverse group of banks and bank activities. Because the design of this approach requires that we customize an examination based

on a bank’s underlying risk characteristics, it allows us to more effectively direct

OCC resources to the banks or activities within banks exhibiting the greatest risk.

In response to the growing divergence in the complexity and scope of operations

between large and small banks, we have divided our day-to-day supervisory operations into two lines of businesses—our Community and Mid-size Bank program

and our Large Bank program.

Our Community/Mid-size Bank line of business oversees over 2,000 national

banks and Federal branches and agencies through our network of district, field, and

satellite offices. When examining this population of banks, examiners use a core set

of examination procedures to draw conclusions about the magnitude of risk and the

adequacy of the risk management system for each of the nine areas of risk. Even

in low-risk banks, we sample, verify, and test the bank’s policies, procedures, and

systems. When risks are elevated; when activities, products, and services are more

complex or present greater financial or compliance risks; or when issues or problems

emerge, examiners will expand the scope of their supervisory activities using more

detailed guidance found in topical booklets of the Comptroller’s Handbook series.

Periodic monitoring of community banks, another key element of the supervisory

process, is also designed to identify changes in the bank’s condition and risk profile,

including new products or services, and to assess bank corrective action on outstanding supervisory concerns between formal onsite examinations. This quarterly

monitoring process allows examiners to identify significant changes in the risk profile of the banks they supervise on a timely basis.

Our Large Bank program focuses on the 24 largest national banks. The supervision of each large bank, overseen out of our headquarters office, is staffed by a

resident examiner-in-charge and a team of examiners and specialists in areas such

as commercial and retail credit, capital markets, bank technology, asset management, and compliance. These examiners and specialists track the quantity and quality of risk management in real time so that our assessments are forward-looking,

as well as historical. This program allows the OCC to develop a more thorough

knowledge of the bank than is possible through the traditional regime of periodic,

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discrete examinations. Over the years, we have also developed, tested, and refined

this supervisory approach expressly to address the special financial and compliance

challenges posed by bigger, more complex, and globally positioned banks. We are

confident that this approach will be effective to supervise the ‘‘mega-banks,’’ those

with assets of a trillion dollars or more, which are forming as a result of recent acquisition activity in the industry.

Today’s national banking system operates not just nationally, but globally. Our

large banks all have operations or a presence overseas. The expansion of our large

banks’ operations across various legal entities and geographic boundaries puts an

increased premium on coordinating our supervisory responsibilities with other domestic and foreign regulators. Domestically, we and the other banking agencies

build upon each other’s supervisory reviews and databases. We routinely share reports of examination and other agency-institution communications and provide each

other with access to our organizations’ structure, financial, and supervisory information. To help facilitate and coordinate our supervision of large, complex institutions,

we share information on proposed examination and supervisory activities for the

coming year and coordinate the planning and execution of those activities. When appropriate, we hold joint meetings with institutions involving matters of mutual

interest and may conduct coordinated reviews or examinations where a business activity is conducted across legal entities. Our London office provides us with examiner expertise to interact with foreign supervisors and provides a platform to examine national bank branches overseas. Our London examiner staff provides a critical

network to deal with home/host country issues, information sharing issues, and

outsourcing issues. We also participate in the Foreign Banking Organization program (along with the Federal Reserve Board) to examine and supervise Federal

branches and agencies in the United States.

We also are deeply involved in the development of international bank supervision

policy through our participation in the Basel Committee on Banking Supervision

and in the Joint Forum, which is an international group of banking, securities, and

insurance supervisors; through our regular dialogue with foreign banking regulators; and through our international and technical assistance programs that provide training and internship opportunities to bank supervisors. In fact, not long ago

we detailed to the Treasury Department four experienced examiners who are now

working in Iraq.

To help meet the challenges of an ever more complex banking industry, our resident and field examiners and specialists are supported by a team of policy specialists, analysts, accountants, and economists in our headquarters office who monitor

industry, market and economic trends, provide technical expertise, and develop analytical tools and models to support our examination functions. For example, our ‘‘Canary’’ system monitors and identifies banks that may have high or increasing levels

of credit, liquidity, or interest rate risks. Our credit risk and economics staffs have

developed various analytical tools that assist examiners to identify portfolio or industry concentrations where risk may be increasing for more in-depth investigation.

Our Risk Analysis unit—staffed by Ph.D. economists—provides on-site technical assistance to our resident staff in evaluating banks’ quantitative risk models and

measurement systems. Our National Risk Committee serves as a coordinating body

to gather and disseminate information from throughout the OCC and the financial

markets on emerging risk issues and advises me and the OCC’s Executive Committee on a quarterly basis of emerging issues and potential policy and supervisory

responses.

Our combination of continuous on-site supervision, with the ‘‘ground level’’ intelligence it provides on each individual bank’s activities and strategies, coupled with

our broader, systemic risk analyses, allows us to quickly adjust our supervisory

strategies to emerging risks and issues that may arise at individual institutions,

within business segments or across the industry as a whole. It also allows us to leverage the diverse skill sets that are needed to supervise our most complex institutions effectively.

Response to the Growing Importance of Operating, Strategic, and Reputation Risk

To address the growing importance of these nonfinancial risks, we have taken a

number of steps to strengthen our supervision and oversight in the critical areas

of audit and corporate governance. In April 2003, we issued an updated examination

booklet on Internal and External Audits. This booklet sets forth our expectations

that well-planned, properly structured, and independent auditing programs are essential to effective risk management and internal control systems. The revised booklet incorporates issues related to recent events related to audit programs, including

the independence provisions of the Sarbanes-Oxley Act and the implementing rules

and regulations of the Securities and Exchange Commission.

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We have also updated our booklet, ‘‘Detecting Red Flags in Board Reports—Guide

for Directors.’’ This guide provides a bank’s board of directors with an overview of

information generally found in board reports and highlights various ‘‘red flags’’—ratios or trends—that may signal existing or potential problems.

In response to the continued evolution of banking products and structures, the

OCC’s Committee on Bank Supervision has recently directed the formation of an internal group within the OCC to oversee and evaluate how new banking products

and structures may affect our supervisory activities. This review committee will

function similar to the new product review committees found at some of our larger

institutions. The committee will have membership from our various supervisory operations, risk, legal, and information technology units.

We have also taken steps with the other U.S. banking agencies in the areas of

audit and corporate governance. For example, in August 2003, the agencies issued

final joint rules that strengthen their authorities to take disciplinary actions against

independent public accountants and accounting firms that perform audit and attestation services required by Section 36 of the Federal Deposit Insurance Act. The

rules establish procedures under which the agencies can, for good cause, remove,

suspend, or bar an accountant or firm from performing audit and attestation services for insured depository institutions with assets of $500 million or more. In

March 2003, the agencies issued an updated ‘‘Interagency Policy Statement on the

Internal Audit Function and Its Outsourcing’’ to reflect provisions of the SarbanesOxley Act and SEC rules regarding auditor independence. The revised policy statement also provides enhanced discussion of the responsibilities of a bank’s board of

directors and senior management with respect to internal audit and reiterates the

need for banks to maintain strong systems of internal controls and high quality internal audit programs.

More recently, the OCC has worked with the Federal Reserve Board and the Securities and Exchange Commission to develop an interagency statement on sound

practices for conducting complex structured finance activities. These activities generally involve the structuring of cash flows and the allocation of risk among borrowers and investors to meet the specific objectives of the customer in more efficient

ways. They often involve professionals from multiple disciplines within a financial

institution and may be associated with the creation or use of one or more special

purpose entities designed to address the economic, legal, tax, or accounting objectives of the customer. In the vast majority of cases, structured finance products and

the roles played by financial institutions with respect to these products have served

the legitimate business purposes of customers, and these products have become an

essential part of U.S. and international capital markets. A limited number of complex transactions appear to have been used to alter the appearance of a customer’s

public financial statements in ways that are not consistent with the economic reality

of the transaction, or to inappropriately reduce a customer’s tax liability.

The interagency statement, which we expect to soon publish in the Federal Register for comment, describes the types of internal controls and risk management procedures that can assist financial institutions to identify and address the reputation,

legal and other risks associated with complex structured transactions. The statement, among other things, provides that financial institutions should have effective

policies and procedures in place to identify those complex structured finance transactions that may involve heightened reputation and legal risk, to ensure that these

transactions receive enhanced scrutiny by the institution, and to ensure that the institution does not participate in illegal or inappropriate transactions. The statement

also emphasizes the critical role of an institution’s board of directors and senior

management in establishing a corporate-wide culture that fosters integrity, compliance with the law, and overall good business ethics.

While regulatory and supervisory initiatives such as these are important to help

banks manage operational, strategic, and reputation risks, it is incumbent on the

banking industry to assume primary responsibility for its own conduct in these

areas. In a speech last year before the American Bankers Association, where I discussed the issues of fair dealing and treatment of customers, I stressed that the ultimate protection for banks is to instill in all employees a dedication to the highest

standards of fairness and ethical dealing; to make clear to employees that no loan,

no customer, no profit opportunity is worth compromising those standards; and to

take swift and decisive action where those standards are violated. The OCC is committed to be vigilant in this area and has and will continue to take responsive action

when we discover abuses or weaknesses. I expect bankers to do the same.

Basel II Developments

Because national banks have international as well as domestic operations, the

OCC must—and we do—become involved in the development of approaches to bank

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supervision at the international level. Currently, the most significant of these approaches is the ongoing effort to revise the 1988 Basel Capital Accord. Let me just

briefly provide you a status report on this effort. There have been a number of articles in the press in recent weeks about positions that U.S. regulators, and the OCC

in particular, may be taking that I believe warrant some clarification and amplification.

First, let me stress that my U.S. colleagues and I share an overarching goal that

Basel II be implemented in a manner that is entirely consistent with the safety and

soundness and continued competitive strength of the U.S. banking system.

As I have said, banks’ current financial and capital positions are strong, but as

the industry continues to evolve, so does its risk profile. Recognizing and adapting

to changing risk profiles and changing risk management practices is critical to

maintaining those strengths. These observations inform our approach to negotiations in the Basel Committee on Banking Supervision regarding Basel II. However,

while we recognize that we can and should improve capital regulation to take into

account changes in banking and risk management, a basic tenet in our negotiations

over reform of the international capital standards is to do no harm. U.S. banks are

world leaders in many aspects of banking—credit cards and securitizations, for example—and we must assure that these important markets are not disrupted or impaired in the name of achieving international conformity in capital rules. In view

of the fundamental strength and resilience of the U.S. financial system, we believe

that reforms to our regulatory and supervisory structure must be adopted in a prudent, reflective fashion.

Thus we are fully committed to three things: First, an open rulemaking process

in which comments are invited and considered, good suggestions are heeded, and

legitimate concerns are addressed; second, a reliable quantitative analysis in which

we can assess the likely impact of Basel II on the capital of our banks prior to its

adoption; and third, a prudent implementation in which we make well-reasoned and

well-understood changes to bank capital requirements and incorporate in those

changes appropriate conservatism. In this regard, I welcome the questions and

issues that Members of this Committee and its staff have raised about this important project and I have repeatedly stressed to the Basel Committee the important

role that Congressional oversight plays in our deliberative process.

The U.S. agencies’ insistence on a thorough and rigorous deliberative process already has resulted in important modifications to the Basel II proposals. One of the

most significant of these issues—and one that U.S. banks were virtually unanimous

in criticizing in response to the Basel Committee’s third consultative paper (CP–3)—

involved the fundamental question of what losses capital requirements should be designed to cover. CP–3 would have calibrated capital to ensure coverage of both expected losses (EL) plus unexpected losses (UL). However, banks in the United States

today generally measure and manage their internal economic capital allocations by

reference to UL only, and most banks consider EL to be covered by a combination

of reserves and credit pricing. As we examined this issue, we became convinced not

only that the banks were conceptually correct in their arguments, but that retaining

the EL plus UL calibration would have severe ramifications—not the least of which

might be to seriously jeopardize the industry’s acceptance of Basel II framework as

being a conceptually sound framework. While many on the Basel Committee resisted this initially, the Committee ultimately put forth a new proposal in October

to modify the calibration of Basel II to UL only. This modification was strongly endorsed by industry participants and has now been agreed to by the Committee.

The Committee announced several other important modifications to CP–3 in January that are responsive to numerous comments we received on CP–3 and the U.S.

agencies’ advanced notice of proposed rulemaking (ANPR) that was issued last August. These modifications include simplifying the proposed treatment for securitizations and aligning it more closely to industry practice and an agreement to find

a prudentially sound solution that better recognizes credit mitigation techniques

used by the industry. Other issues are still under discussion by the Committee’s

various technical working groups and are scheduled to be considered by the Committee at its meeting in May.

Probably the most difficult policy issue remaining involves the appropriate riskbased capital treatment of certain retail credit products—unused credit card lines

in particular. This issue is critically important for national banks and for the cost

and availability of consumer credit. It is also an area in which consensus has been

hard to come by. Given the prominence of the retail lending business for U.S. banks,

and for national banks in particular, there is little room for substantive compromise,

and the OCC will not accept provisions that are likely to unduly disrupt or disadvantage established, well-functioning business practices. We believe that this

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issue will be resolved in a manner that appropriately addresses safety and soundness objectives without altering legitimate business practices.

Notwithstanding the difficulty of these issues, the Committee’s goal is to be in a

position by mid-year to release a text that will provide the basis for each country’s

national implementation process. Let me reiterate that point: The release of the

next round of proposals does not represent a final agreement or accord; rather, it

is the platform from which we will launch our more in-depth domestic deliberative

process. In the United States, that process will have several key steps.

First, the U.S. agencies will conduct a fourth quantitative impact study (QIS 4)

in the third and fourth quarters of this year. This study will be based on the Committee’s mid-year release and will differ in some important aspects from the Basel

Committee’s earlier quantitative studies. QIS–4 will not only be conducted against

the background of a more fully articulated proposal, but will also include a more

prominent supervisory role to ensure greater reliability and consistency in survey

results than has occurred in the past. We continue to believe that we cannot responsibly adopt final rules implementing Basel II until we have both determined with

a high degree of reliability what the impact will be on the capital of our banks, and

we have made the judgment that the impact is acceptable and conducive to the

maintenance of a safe and sound banking system in the United States. We believe

the results of QIS 4 will be more useful than any data we currently have in determining the magnitude of the impact of Basel II on bank capital and potential competitive inequities, as well as determining ultimately what to do about them.

Second, in another effort to increase our practical understanding of the effects of

Basel, the U.S. agencies have commenced an operational risk benchmarking review

at a number of the largest institutions. Information obtained through this effort will

enhance agency understanding of current qualitative and quantitative operational

risk practices and will assist agency efforts to develop additional supervisory guidance and training materials for banks and examiners on the operational risk component of Basel II. Throughout this period we will continue our dialogue with banks

and other interested stakeholders on various issues that Basel II may raise.

Those projects and discussions will help us in the third key step in Basel implementation, developing a joint notice of proposed rulemaking (NPR) that will set

forth the proposed regulatory text for Basel II in the United States. Currently we

anticipate that such an NPR will be released for public comment in late 2005 or

early 2006. At the OCC, we have made a preliminary determination that this rulemaking will be a ‘‘significant regulatory action’’ for purposes of Executive Order

12866. Consequently, we will prepare and submit to the Office of Management and

Budget’s (OMB) Office of Information and Regulatory Affairs (OIRA) an economic

analysis that includes:

• a description of the need for the rules and an explanation of how they will meet

the need; an assessment of the benefits anticipated from the rules together with,

to the extent feasible, a quantification of those benefits;

• an assessment of the costs anticipated from the rules together with, to the extent

feasible, a quantification of those costs; and

• an assessment of potentially effective and reasonably feasible alternatives to the

planned regulation and an explanation why the planned regulatory action is preferable to the identified potential alternatives.

We have begun discussions with the OMB’s OIRA regarding how these analyses

will be designed and conducted. Our analysis will be published as part of our notice

and comment process.

Finally, as the rulemaking process for the domestic implementation of Basel II

moves forward, we and the other U.S. agencies are exploring the implications that

Basel II may have on nonmandatory banks and what, if any changes we should

make to our capital regulations for those banks. Any such changes will, of course,

be subject to public notice and comment.

As my testimony conveys, while we have made important strides in trying to develop a more risk-sensitive capital framework for internationally active banks, there

is still a long way to go before Basel II is completed and adopted. As I have repeatedly stated before Congress and in the Basel Committee, a new accord cannot be

completely finalized until national implementation procedures have been completed

and I am committed to a notice and comment process that is open and fair and responsive to public comments. The OCC and other U.S. agencies have recognized the

possibility that, even in the late stages, public comments might reveal flaws in the

proposal that will need to be addressed before we can issue final implementing regulations. The OCC’s ultimate willingness to sign onto Basel II is going to depend on

whether we are satisfied with the final product.

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Conclusion

In conclusion, Mr. Chairman, the national banking system is sound, and its recent

performance has been strong. It has successfully weathered the recent recession,

and it is responding in dynamic fashion to the changes in the financial services marketplace. The OCC, too, is keenly focused on keeping pace with change—by improving the approaches we use to supervise the industry, and by striving to ensure that

national banks remain the safe and sound, competitive, and high integrity engines

of our economy that they were designed to be. We look forward to working productively with you, with the Members of this Committee, and with State officials as

we pursue our efforts to achieve that goal.

—————

PREPARED STATEMENT OF DONALD E. POWELL

CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION

APRIL 20, 2004

Mr. Chairman, Senator Sarbanes, and Members of the Committee, thank you for

the opportunity to testify on behalf of the Federal Deposit Insurance Corporation

regarding the condition of FDIC-insured institutions and the deposit insurance

funds. My testimony will briefly review the recent record earnings and outstanding

financial performance of FDIC-insured institutions and the condition of the deposit

insurance funds, touch upon potential risks to the industry, and discuss the implications of industry consolidation and some related questions that we believe will drive

discussions among banking policymakers going forward.

Condition of FDIC-Insured Institutions and the FDIC Insurance Funds

I am pleased to report that FDIC-insured institutions are as healthy and sound

as they have ever been. The industry earned a record $31.1 billion in the fourth

quarter of 2003, marking the fourth quarter in a row that earnings set a new high.

The results for the fourth quarter also brought the industry’s earnings for the full

year to a record $120.6 billion, surpassing the previous annual record of $105.1 billion set in 2002. The return on assets (ROA) in the fourth quarter and for the entire

year was 1.38 percent, equaling the quarterly record set earlier in the year and easily surpassing the previous all-time annual high of 1.30 percent in 2002.

Underlying the current financial strength of the industry have been the cumulative effects of the 10-year economic expansion of the 1990’s and certain factors

that tended to insulate banks from the most severe effects of the 2001 recession.

Improvements in underwriting and risk management practices helped to limit the

effect of credit losses on industry earnings during and after the recession. Meanwhile, strong growth in mortgage loans, a steep yield curve, new sources of fee income and cost containment efforts by banks helped boost the net operating income

of the industry. Record earnings 2 years in a row, record returns-on-assets, and a

strong capital foundation are all indicators that banks not only weathered the recent economic downturn—but also have been a source of significant strength for the

economy and for the American consumer.

This strength is mirrored in the strength of the FDIC’s insurance funds. As of December 31, 2003, the balance of $33.8 billion in the Bank Insurance Fund (BIF) represented 1.32 percent of estimated BIF-insured deposits, well above the statutory

target reserve ratio of 1.25 percent. The Savings Association Insurance Fund (SAIF)

ratio stood at 1.37 percent at year-end 2003, with a balance of $12.2 billion. The

BIF reserve ratio rose during 2003 as expected losses fell, while the SAIF reserve

ratio remained essentially unchanged from year-end 2002. A combined BIF and

SAIF fund would total $46 billion with a reserve ratio of 1.33 percent of estimated

insured deposits.

In November 2003, the FDIC Board of Directors voted to maintain the existing

BIF and SAIF premium rate schedules for the first half of 2004. The FDIC’s analysis indicates that it is unlikely the reserve ratio for either fund will fall below the

statutory target of 1.25 percent in the near future. For example, with the BIF ratio

at 1.32 percent, assuming no deposit growth, insurance losses on the order of $1.8

billion would be required to drop the ratio to 1.25 percent. For insured deposit

growth alone to reduce the ratio to this level, assuming no change in the BIF fund

balance, growth of nearly 6 percent would be required. Neither BIF insurance losses

nor BIF deposit growth has approached these magnitudes recently, and we do not

foresee any combination of insurance losses and deposit growth that would drive the

reserve ratio near 1.25 percent in the coming months, although these forces could

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result in a decline from current ratios. As a result, we do not foresee a need for

additional premium income at this time.

As you are aware, the FDIC’s concerns about the deposit insurance system relate

to the way it is structured. We cannot price deposit insurance based on risk, we cannot manage the fund’s size relative to our exposure, and we maintain two funds

even though the historic rationale for doing so has gone away. There is broad agreement on the key elements of a deposit insurance reform package and the FDIC remains willing to work with this Committee to achieve reform as soon as possible.

Potential Risks

We cannot assume that the economic environment of the next decade will necessarily be as favorable to the industry as our recent experience. The world is

changing in unprecedented ways and the FDIC continuously monitors economic conditions and emerging risks in the banking industry in order to maintain its

preparedness. The primary vehicle for monitoring and addressing risk is the supervisory process, which has been enhanced significantly over the past decade. Moreover, as the banking industry has become more sophisticated, the FDIC has created

cutting edge risk management techniques to identify, measure, and manage risk to

the insurance funds. The cornerstone of FDIC’s risk management philosophy and

practice is an integrated, multidisciplinary approach that brings together economists, examiners, financial analysts, and others to analyze and respond to risks in

the system.

Using this approach, the FDIC expects continued good performance for the banking sector, based on the industry’s solid fundamentals and generally favorable economic conditions. The economy grew at a 6 percent annual rate during the last half

of 2003 and is expected to grow at a 4 percent pace this year.

Despite the generally positive recent economic news, our integrated analysis reveals several trends that could pose difficulties for the banking industry and the

FDIC in the future. The FDIC analyzes risks that are generally known to exist as

well as risks that appear to have a low probability of occurring, but would have a

high impact if they did. The intent of our analysis is to ensure we are capturing

all risks that could affect the banking industry and the deposit insurance funds.

It is important to recognize the volatility of financial markets and the potential

for disturbances to spread throughout the system. In today’s interconnected financial system, problems that initially appear to be localized could lead to a more widespread loss of confidence with a resulting impact on liquidity throughout the system.

This issue bears watching to ensure that financial market disruptions do not

produce significant banking problems going forward. The major actors in the financial markets are large, well-diversified organizations that continue to grow. Later

in my testimony, I will discuss the increasing shares of industry assets, deposits,

and revenues held by just a few large banking organizations and the implications

of this trend for the future of banking.

Another area of concern is household balance sheets. The household sector has

been the engine for banking growth through the 2001 recession and beyond, but

sources of concern include the near record pace of personal bankruptcies—exceeding

1.5 million in 2003—and rising household indebtedness. Total household debt is at

an historical high of 112 percent of disposable personal income. The lowest mortgage

rates in more than a generation have prompted households to take out $1.4 trillion

in new mortgage debt since the end of 2001. Household indebtedness also increased

as a result of a market and technology-driven revolution in consumer lending that

created a system with unprecedented access to credit and convenience in its use.

Perhaps even more important than the absolute level of debt is the fact that the

amount of money households must pay to keep debts current is increasing. This is

occurring despite the prolonged period of low interest rates, which would normally

be expected to lower debt service. Homeowners now use about 14 percent of disposable income to meet their major financial obligations, versus about 12 percent in

1993. The increase in renters’ financial obligations is even more striking at about

31 percent of disposable income versus about 24 percent in 1993. Escalating household indebtedness raises concerns about the sustainability of the growth in

consumer spending, especially when interest rates rise. A trail-off in consumer

spending could also occur once the effects of the 2003 tax cut and 2003 mortgage

refinancing boom run their course.

Escalating household debt raises concerns about the sustainability of consumer

spending and the ability of borrowers to meet obligations when interest rates rise.

In particular, households that have a greater exposure to variable rate consumer

loans and adjustable rate mortgages, and those with weaker credit histories and

balance sheets, could experience some problems meeting their obligations. A related

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concern is that rising interest rates could cause some stress in certain housing markets, where prices have been more volatile than the rest of the Nation.

However, this is uncharted territory. The commoditization of credit has created

a much more sophisticated financial economy that may be able to tolerate higher

and rising debt levels. Our concerns are tempered, however, by the strength of

household assets and the strengthening job and wage data we have seen in recent

months.

In particular, I am concerned that those at the margins of the credit system will

be adversely affected. Households that have greater exposure to variable rate consumer loans and adjustable rate mortgages and those with weaker credit histories

and balance sheets could experience some problems meeting their obligations. Often,

these are consumers who lack a basic understanding of how money works in our

society—and therefore lack the tools necessary to save and manage money. That is

why I believe that promoting the financial education of our society’s unbanked segment is one of the FDIC’s most important goals, and why the FDIC has developed

the Money Smart financial literacy program.

Since the rollout of Money Smart, FDIC has distributed more than 111,000 copies

of the curriculum and trained over 5,000 instructors. Money Smart is currently

available in English, Spanish, Chinese, Korean, and Vietnamese. The FDIC has

taken the lead in establishing financial education partnerships with communities

and bankers. The FDIC has entered into over 600 local Money Smart Alliances

across the country, including national partnerships with the U.S. Department of

Labor, the U.S. Department of Housing and Urban Development, the Association of

Military Banks of America, Goodwill Industries International, the National Coalition for Asian Pacific American Community, and the Internal Revenue Service. Last

year, for example, the FDIC’s work during the 2002 tax season with the ‘‘Back of

the Yards’’ voluntary income tax assistance site in Chicago helped over 600 families

file tax returns and receive $1.1 million in earned income tax credit refunds. Many

of these families also opened their first bank accounts through this initiative.

Another challenge facing banks is high concentrations in commercial real estate.

As of the fourth quarter 2003, national vacancy rates for office, retail, and warehouse space stood at or near historic highs of 17.9 percent, 12.9 percent, and 10.5

percent, respectively, and were even higher in some markets. Nevertheless, commercial real estate concentrations at banks are high and increasing. The national median concentration of commercial real estate to capital is 164 percent, up from 92

percent in 1993. Moreover, concentrations are particularly heavy in the West and

Southeast. In our San Francisco and Atlanta Regions, the median commercial real

estate concentrations are 327 percent and 284 percent, respectively.

So far, poor commercial real estate fundamentals have not resulted in loan performance problems at banks—national charge off rates are below 0.1 percent and

the nonperforming ratio is 0.8 percent. Improved underwriting and regulatory requirements, increased public ownership and transparency of commercial real estate

transactions, and low interest rates have all acted to buffer banks from commercial

real estate losses. Despite the good performance to date, given the significant problems that resulted from commercial real estate in the late 1980’s and early 1990’s,

the FDIC has implemented enhanced commercial real estate monitoring programs,

particularly in areas with very heavy concentrations.

As with the household sector, there are concerns that some commercial real estate

borrowers could be affected if debt service increases due to a rise in interest rates.

On the other hand, rising interest rates are normally accompanied by resurgence

in economic activity. For commercial real estate, that could mean an increase in potential renters and rental rates. Nevertheless, the high and rising ‘‘twin deficits’’—

national and trade debt—coupled with the ongoing fall of the dollar have raised

some concerns about a dollar collapse. While a collapse seems unlikely, given foreign

reliance on dollar holdings, among other factors, it could lead to a rise in rates without concurrent economic growth.

Implications of Industry Consolidation

The ongoing consolidation of the banking industry means that there are a few

very large institutions that represent an increasingly significant share of the FDIC’s

exposure. Once the recently announced mergers are complete, there will be three

banking companies whose assets are in the range of $1 trillion each. Their combined

assets will account for approximately 30 percent of the assets of FDIC-insured institutions. The next four largest holding companies will have assets in the range of

$200 to $400 billion, and they will account for another 13 percent of industry assets.

The top 25 banking companies hold over one-half of industry assets, while the top

100 hold almost three-quarters.

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The largest banking institutions are global, highly diversified organizations. They

are positioned well to absorb losses from local economic problems or idiosyncratic

risks in any particular lines of business. The external risks posed to these firms are

essentially macro risks—reflecting the same factors that could threaten the entire

financial system. Thus, the major risk the deposit insurance system faces is the risk

that the economy or the financial system would suffer extreme deterioration.

In the absence of extreme economic or financial disruption, the risk from these

companies arises from the challenges of managing such large, complex organizations. Should these internal risks result in significant problems at a large bank, the

situation could also pose risks to the system as a whole. This is why it is so important for owners, managers, and directors of these organizations to adhere to the

standards of good corporate governance and risk management and for regulators to

ensure that these standards are met.

To enhance our understanding of the risks these institutions may pose, the FDIC

has placed dedicated examiners in the eight largest institutions. These dedicated examiners work closely with the resident examination staff of the primary Federal

regulator.

One question we face is whether the consolidation of the banking industry has

gone too far or will go too far in the future. Or conversely, is the 10 percent deposit

cap increasingly an impediment to the appropriate market evolution of the industry?

First, I would note that the degree of consolidation is a relative notion. Compared

to the industry 20 years ago, banking is certainly more consolidated. But compared

to other industries or banking systems in other countries, it does not appear to be.

We are not close to having a banking organization with branches in all 50 States.

A standard measure of industry concentration is the market share of the top five

firms in an industry. Table 1 provides this measure for major U.S. industries. As

the table shows, banking is a relatively unconcentrated industry by this measure.

In fact, banking is less concentrated than the table would indicate, since the table

compares only publicly traded companies and less than 10 percent of banks and

thrifts are publicly traded.

There appear to be several public policy reasons for the 10 percent deposit cap.

One purpose of the cap is to protect bank customers from anticompetitive behavior

that can result from a highly concentrated industry. This makes sense, but it is not

clear why banks should be treated differently in this regard from other firms. The

banking industry is highly competitive, and standard antitrust measures appear

sufficient to ensure that it will continue to be competitive.

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Another purpose for limiting banks to a 10 percent share of national deposits is

to limit the concentration of risk that any one bank poses to the deposit insurance

system and the financial system in general. As mentioned earlier, the most significant risk to these banks is the risk of severe economic disruption, and I would offer

two observations here. The first is that during the past two decades the economy

has experienced longer periods of expansion and a milder recession. This reflects:

(1) the benefits of what has been called the free-market consensus; (2) the ability

of a transformed financial system to absorb economic shocks; and (3) generally

sound monetary and fiscal policies. So long as these factors remain in place, it

seems reasonable to expect performance over the business cycle to be generally favorable.

Of course, we cannot rule out adverse scenarios. The question, then, is whether

it matters under such scenarios if the assets of the industry are largely concentrated

in a dozen or so banks or in just a handful.

Putting aside risk stemming from the economy or overall financial system, the

next question involves the risk posed by a single banking organization. The risk

would seem to hinge on the tradeoff between the benefits of scale and diversification

and the challenges of managing large complex organizations. The performance of

large banks in recent years suggests the tradeoff has thus far been favorable.

As we move forward, my sense is that regulators, policymakers, and market participants will be able to assess whether the tradeoff remains favorable. Put simply,

if these banks show signs of becoming too-big-to-manage, I would expect the market

to slow, if not reverse, the course of consolidation and regulators to impose stricter

sanctions. Ultimately, if these measures are absent or ineffective, I would expect

policymakers to step in. This approach seems to be a better gauge of the appropriate

scale of banking organizations than does an arbitrary fixed cap.

My bias is to let market forces determine the evolution of the banking industry.

I believe this has served us well in the post-crisis period and I expect that it will

continue to be the best way to ensure that banks are meeting the needs of households and businesses.

Having said that, it is apparent that continued consolidation will present challenges to how the FDIC administers the deposit insurance system. The fact that our

risk is increasingly concentrated in the largest banks has implications for how we

assess risk, the appropriate way to fund deposit insurance, and the implications of

problems at, or the failure of, a large bank.

In terms of assessing risk, the FDIC obviously relies heavily on the efforts of the

bank examiners and supervisors at the FDIC and our sister agencies. This has

served us well and I expect it will continue to do so. From a purely financial point

of view, however, it seems that the risk the FDIC faces is not that dissimilar from

the risks that the market prices on a regular basis. As large banks evolve, the FDIC

could look more to market instruments—like reinsurance contracts or catastrophe

bonds—to help us assess our large-bank exposure.

With respect to funding deposit insurance, one question that often arises (and indeed did so the last time this panel appeared before this Committee) is whether the

deposit insurance funds are adequate to handle the failure of a large bank. Some

rough numbers may be helpful here. We have historical data on the losses per dollar

of assets at failed banks. This loss rate has been lower for large banks than for

smaller ones. The loss rate for larger banks has been in the neighborhood of 5 to

10 percent, although there are some caveats to note here. The first is that the largest failures involved banks in the range of $40 billion in assets—nothing approaching the size of the largest banks today. Second, this experience is largely from the

period before prompt corrective action, least-cost resolution, and depositor preference. With that in mind, assuming a loss rate of 5 percent, the failure of a $1

trillion bank would cost $50 billion. This is just slightly more than the two deposit

insurance funds combined.

Of course, if a large bank were to fail, the question arises as to whether it should

be handled under the systemic risk exception provided for in FDICIA. As you know,

this provision requires that the FDIC Board, the Federal Reserve Board, and the

Secretary of the Treasury be in agreement that the bank should be handled outside

the bounds of the normal ‘‘least-cost’’ manner. I should stress that even if this judgment were made, it does not mean that shareholders and all creditors will be protected from loss.

Suppose that, in our example, the finding of systemic risk resulted in a loss rate

that approached the higher end of the range mentioned above. A 10 percent loss

rate would result in a cost of $100 billion. Congress in FDICIA made it clear that

this additional $50 billion would be funded by an ex-post assessment on the banking

industry and placed more heavily on the larger banks.

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To put these amounts in perspective, FDIC-insured institutions earned $120 billion last year and hold additional capital above the well-capitalized level in the

amount of nearly $200 billion. This capital stands behind the funds and would be

available to shield taxpayers in the event of a large failure.

Related Questions for Policymakers

While we are certainly pleased with the current condition of the industry and the

strength of the bank safety net, banking is in the midst of a profound transformation. The role of banks in the marketplace has changed in the past 20 years

and this transformation continues apace. There are some concerns that banks’ share

of the financial pie has been shrinking. While some have argued that banks are ‘‘dinosaurs,’’ banks actually have been reforming their intermediary role in important

ways that have propelled them to a more competitive position in the financial marketplace. They now provide better products and services for their customers, and deliver record earnings for their shareholders. Banking organizations remain a critical

part of the modern flow of funds that has broadened the availability of credit in the

U.S. economy.

Nonetheless, while banking organizations have prospered, traditional banking—

the combination of deposit-taking and commercial and industrial lending—has

become a smaller part of the financial system and of banking organizations themselves. Bank commercial and industrial lending has declined sharply relative to

total lending, falling from about 25 percent of total nonfinancial business sector debt

50 years ago to slightly more than 15 percent. Traditional business lending also

makes up a smaller share of commercial banking’s loan portfolio. Operating loans

to businesses now constitute less than a fourth of total commercial bank lending—

down from 40 percent 20 years ago. Moreover, banks have lost ground in the competition for savers’ funds. Since 1980, the total value of money market, mutual fund,

and deposit instruments in the United States grew from just under $2 trillion to

some $11.6 trillion. During this time, the share of these instruments issued by

money market funds and mutual funds increased from 7 percent to 55 percent,

while the share issued by banks fell from 90 percent to 41 percent.

Along with the consolidation trend, these developments raise some fundamental

questions for policymakers that relate to safety-net arrangements as well as bank

regulation and supervision.

Federal deposit insurance was designed specifically to protect traditional bank

intermediation. A continuing challenge is how best to protect the stability of the system as savers’ choices continue to expand and bank deposits become less important

in the overall financial system. Federal deposit insurance works well for traditional

community banks. For the largest banking organizations, as they increasingly engage in diverse, nontraditional activities, it makes sense to consider whether different safety-net arrangements might be more suitable for this segment of the industry. Since some aspects of our regulatory system already are tailored to recognize

the differences between large and small institutions, we should consider the explicit

creation of a two-tiered safety net that better addresses these differences.

In many respects, we already have the makings of a two-tiered approach. First,

large banks are supervised by teams of examiners who are in residence year-round

while small banks are visited at regular intervals by either Federal or State regulators. Second, large banks are much more exposed to the discipline of the capital

markets and the ratings agencies—both of which serve to assist regulators in gauging the banks’ conditions. Third, current law permits a two-tiered system of pricing

deposit insurance. Fourth, we are negotiating a capital accord, Basel II, which will

result in a two-tiered system of capital regulation—one for large, internationally active institutions and one for all others. Finally, if a large bank gets into trouble and

threatens the overall system, our laws contemplate the possibility that it could be

resolved outside the bounds of our current ‘‘least cost’’ resolution procedures.

We expect the gulf between large and small institutions—and the gulf between

the kinds of business they are engaged in—to continue growing. This consolidation

of the banking industry will pose interesting questions for policymakers. For example, I believe that we should now begin to think through the merits of moving further toward an explicit, two-tiered system that includes the possibility of having

larger institutions in a separate risk pool. There are many issues to consider, including funding arrangements for problems that may arise in the separate risk pool for

large institutions. The FDIC could also look more to market instruments—like reinsurance contracts or catastrophe bonds—to help us assess our large-bank exposure.

We also should ensure that regulatory burden does not weigh too heavily on community banks and stifle the innovation and consumer choice that are hallmarks of

our system. This can be unduly burdensome for community banks and threatens to

deter new entry into banking. Low barriers to entry are key to ensuring continued

71

innovation and customer service in the industry. From my own personal experience

as a banker, I know all too well how heavy this burden can be.

The FDIC is taking action to reduce undue regulatory burden to a minimum for

institutions of all sizes. In addition, FDIC Vice Chairman John Reich is leading an

interagency effort to identify unnecessary burden, duplication, and outmoded restrictions on both large and small financial institutions. Under the Economic

Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA), Congress required the Federal banking agencies and the National Credit Union Administration

to review all regulations every 10 years for areas that are outdated, unnecessary,

or unduly burdensome.

The agencies have jointly published the first two of a series of notices soliciting

comment on regulations in a number of areas, and have been conducting outreach

sessions with bankers and consumer/community groups. Armed with this input, the

agencies will conduct a comprehensive review of banking regulations and will report

to Congress on their findings and the actions they have taken, or plan to take, to

reduce the level of burden. The agencies also anticipate sending this Committee a

list of legislative areas for consideration.

Another broad question facing policymakers will likely be how to handle the convergence of interests between banks and firms operating in the larger marketplace.

As pointed out earlier, barrier after barrier has come under pressure over the years

as the market provided the means to produce and deliver more innovative products

to financial consumers. The repeal of branching laws and the Glass-Steagall Act is

part of a market driven continuum that will lead us to the doorstep of the last remaining barrier—the barrier between banking and commerce.

Linkages between banking and commerce exist for a number of grandfathered

thrift holding companies, CEBA banks and some industrial loan companies. From

a public policy standpoint, the benefits of this limited experimentation with the mixing of banking and commerce include a more competitive banking marketplace,

more choices for consumers, and, to a limited extent, the existence of a laboratory

for alternative modes of regulation. Concerns also have been expressed about allowing any expansion of the mixing of banking and commerce. These concerns have centered on concentrations of economic power, conflicts of interest, and a transfer of a

subsidy from the insured bank to affiliates. These issues are present, of course, for

any large financial conglomerate. Conflicts of interest are possible even for standalone community banks, where majority shareholders may have commercial business interests. The challenge is to ensure that supervisory and regulatory structures

achieve the best of two worlds—both allowing for continued market innovation and

providing adequate protection for the bank safety net.

Just as many structural and procedural concerns were addressed during the development of the Riegle-Neal Act and the Gramm-Leach-Bliley Act, I believe the

same is possible in this instance. As the market continues to mature in this area,

the appropriate boundaries between banking and commerce will be a significant

matter for discussion among policymakers going forward.

A final fundamental question for policymakers in the area of bank supervision

concerns the future of capital regulation. Capital is perhaps the single most important part of a bank’s balance sheet. It promotes confidence in the organization as

a going concern and enhances and diversifies the options available to bank management. Capital allows the bank to continue functioning in the face of unexpected

events and errors in judgment, and in times of crisis or systemic difficulty.

The challenge for policymakers, in this dynamic and complex financial services

marketplace, is to get capital right. We must actively work to ensure that our definition of capital is limited only to those instruments that are able to effectively cushion the bank during times of distress. And we must ensure capital adequacy—that

there is enough to absorb losses, ensure ongoing operations, and promote customer

confidence during stressful periods.

As the sophistication of the financial markets grows, and innovations allow for

more complex transactions, the regulators must be vigilant and ensure that our core

Tier 1 capital elements have the ability to cushion banks against loss on a goingconcern basis. Tier 1 should be the regulatory standard reserved for the highest

quality of capital, and there is no secret of my concern about continuing to allow

trust preferred securities to be included in that select category. Trust preferred securities are issued by bank holding companies and carry a cumulative obligation to

pay dividends. Under a recent accounting change, they are now categorized explicitly as debt. For insured institutions, the appeal of these and other similar instruments is that they combine the tax advantages of debt with the regulatory stamp

of approval of equity. Community banks that are members of holding companies like

the idea of being able to tap capital markets with these securities. Yet they result

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nient than GAAP. If the bank regulators do not acquiesce to allowing banks this

favorable capital treatment directly, there is the issue of regulatory capital rules

that appear to provide an advantage to holding company membership.

Weaning the banking system from reliance on a previously approved element of

Tier 1 capital would, of course, raise a host of difficult transitional and grandfathering issues. We should make these difficult judgments with the benefit of industry comment, and arrive at a conclusion as to what types of hybrid capital instruments provide meaningful capital support against the prism of what truly is in

the long-term best interest of banks, the financial system as a whole, and the bank

safety net.

With respect to the Basel II negotiations, the FDIC supports the underlying

premise of the agreement and is working hard to complete our work and move toward implementation. Nevertheless, there remain some important issues at stake

for the bank safety net, the regulatory structure, and Congress. The implementation

of the Basel II agreement will certainly trigger an intensive public discussion of the

workings of our domestic Prompt Corrective Action (PCA) framework—the underlying law that governs our system of capital regulation in America. I know of no

disagreement among my U.S. regulatory colleagues that the outcome of this public

debate will be a capital regulatory structure that combines the best elements of the

PCA framework with the enhanced risk metrics of Basel II. Indeed, as the FDIC

has indicated on many occasions, this must be the outcome.

While policymakers must carefully navigate the intersection between PCA and

Basel II in order to protect the safety net, we also believe our banking system would

benefit from strong capital adequacy in other ways as well. Our banks are among

the most well-capitalized in the world—and they are second to none in competitiveness, innovation, and market share. Yet their complexity seems to be attracting

more and more oversight and regulation—and not necessarily only from the consumer protection side. A strong industry capital base will allow the regulators some

room to permit the marketplace to take its course—both in terms of innovations

that better serve consumers, but also in remaining competitive with firms overseas.

Lowering capital in these institutions will increase the risk of an institution’s failure

and will lead to significant regulatory intrusion into the business of these large

firms—and perhaps stifle many of the market driven benefits we have come to expect from the financial services industry.

Conclusion

While America’s banks—and the deposit insurance funds—are as healthy as they

have ever been, it is nonetheless clear that the industry is undergoing significant

structural change. Accordingly, our system of bank regulation will also have to

change in order to meet the challenges posed by this dynamic financial environment.

Banks are positioned to continue to play a vibrant role in the free-market economy and perform vital intermediary functions through the development of future

products and services that are well beyond anything we can imagine today. As this

process evolves, accompanying structural and regulatory changes will be needed to

ensure the bank safety net remains effective and able to fully meet its public policy

purpose. Further, our role as regulators is to protect consumers from abusive practices and promote safe and sound banking practices. This underlying mission will

remain the same regardless of what is occurring in the marketplace, and our job

is to ensure the right balance is struck as these innovations continue.

Because so many of these changes could impact the deposit insurance funds, the

FDIC will continue to provide this Committee with our analysis and views as we

work together in the coming years to ensure the safety and soundness of a changing

industry.

This concludes my testimony. I will be happy to address any questions that the

Committee might have.

—————

PREPARED STATEMENT OF JAMES E. GILLERAN

DIRECTOR, OFFICE OF THRIFT SUPERVISION

APRIL 20, 2004

Introduction

Good morning, Chairman Shelby, Senator Sarbanes, and Members of the Committee. Thank you for the opportunity to testify on the financial condition and performance of the thrift industry. It is my pleasure to report on a thrift industry that

73

1The number reported in a recent financial publication regarding the ratio of Federal versus

State thrifts failed to include State savings banks. In the aggregate, as of the end of 2003, 42

percent of thrifts—including State savings banks—were State chartered and the remaining 58

percent federally chartered. 2 A holding company structure may contain more than one holding company. As of the end

of 2003, these 605 OTS-supervised holding company structures operated 971 holding companies.

is strong and growing in asset size. While we continue to maintain a watchful eye

on interest rate risk in the thrift industry, profitability, asset quality, and other key

measures of financial health are at, or near, record levels. The average equity-toassets ratio is over 9 percent, and 99 percent of thrifts are well-capitalized.

A favorable interest rate risk environment, accompanied by record mortgage originations and sales, has produced strong profitability for the thrift industry for the

past 5 years. Equally important to this sustained period of profitability are good

stewardship by thrift managers, earnings diversification, and good asset quality.

Other important factors that have contributed to the industry’s success are the statutory and regulatory reforms initiated to strengthen the banking system. The reforms—including comprehensive capital standards, stronger corporate governance

and internal control standards mandated by the Sarbanes-Oxley Act, uniform standards for lending, operations and asset growth, and prompt corrective action (PCA)

requirements—have significantly improved our banking system. In addition, the

banking agencies have been effective in keeping pace with changes in the institutions we regulate. For its part, the OTS continually works to provide specialized

training, rigorous accreditation and professional development programs, and other

supervisory tools, to ensure that our staff is capably equipped to supervise a dynamic and growing industry. In addition, our employees are of long tenure and are

well-seasoned, with an average 15 years of OTS experience.

Condition of the Thrift Industry

As of December 31, 2003, there were 928 OTS-regulated thrifts, holding assets of

$1.1 trillion. In addition, there were 485 State-chartered savings banks that have

the FDIC as their primary Federal regulator and the vast majority of which have

operating strategies substantially similar to thrifts.1

While financial services consolidation continues to reduce the overall number of

thrift institutions, industry asset growth remains strong. This is due to growth within existing thrifts and to the fact that various financial institutions continue to

choose the thrift charter because of the advantages it provides in the delivery of financial services. Charter choice is a privilege available to American financial institutions, and it continues to flourish as institutions change and adapt their business

strategies and focus.

In addition to supervising 928 thrift institutions, OTS supervises thrift holding

companies. As of the end of 2003, OTS regulated 605 thrift holding company structures 2 with consolidated assets of approximately $6 trillion. As the only consolidated Federal regulator both chartering the depository institutions and overseeing

their holding companies, OTS has a unique supervisory role. This provides us with

the opportunity to monitor and regulate all aspects of the institution’s operations

and holding company affiliate activities. The holding companies we oversee are quite

diverse, ranging from large, multinational corporations to small ‘‘shell’’ companies

with few assets other than their thrift charter.

The demographics of thrift institutions are also quite diverse. While numerous

larger thrifts provide financial products and services nationwide or across sizable regional markets, most thrifts are generally smaller, community-based organizations

that provide retail financial services in their local markets. As of the end of 2003,

66 percent of thrifts had assets of less than $250 million. Although small, these institutions reach into many small American towns fortunate to have the option of a

local community banker.

Thrifts provide substantial services that encourage homeownership and affordable

housing, and contribute to economic growth. Thrifts hold over $730 billion in housing-related loans and securities, including $540 billion in whole single-family loans,

which comprise one half of total thrift assets. In addition, the industry maintains

60 million insured deposit accounts. Thrifts compete effectively with other

financial services providers to deliver a wide range of products and services to

American consumers.

Thrifts utilize the secondary market effectively, selling approximately $769 billion

in single-family mortgage loans to Fannie, Freddie and other secondary mortgage

market participants in 2003. In addition, as of December 31, 2003, the Federal

Home Loan Banks advanced $190 billion to thrift institutions, representing 17 percent of thrift liquidity.

74

EARNINGS AND PROFITABILITY

Recent earnings and profitability of the thrift industry have been strong, with

consecutive annual records in 2001, 2002, and 2003. For 2003, the industry reported

earnings of $13.7 billion, eclipsing the prior record of $11.8 billion in 2002. Annual

earnings were $10.2 billion in 2001.

The industry’s annual return on average assets (ROA), a key measure of profitability, was a record 1.29 percent for 2003, breaking the prior record of 1.21 percent

posted in 2002. Industry ROA was 1.07 percent in 2001. This was the first time that

industry ROA exceeded 1 percent in 3 consecutive years since the mid-1950’s.

While the historic level of thrift earnings is partially attributable to record loan

origination and sales volume, the underlying strength and stability of thrift earnings has also been driven by diversification of income sources and continued strong

asset quality. The industry’s success over the past decade in expanding its line of

products and services, such as mutual fund and annuity sales, trust activities, and

transaction accounts, has enabled it to diversify its income stream and generate

more stable earnings. Income from these activities measured 0.94 percent of average

assets for 2003, up more than 400 percent from 0.17 percent in 1990. Together with

improved risk management techniques, higher proportions of noninterest income

have helped stabilize thrift income and provide better insulation against interest

rate fluctuations.

The thrift industry was an active participant in the Nation’s recent refinancing boom and homeownership expansion. Thrifts originated over $730 billion in singlefamily mortgages in 2003, accounting for one in every five mortgages made in the

United States for this time period. Income from mortgage lending, loan servicing,

and other mortgage banking activities helped boost recent earnings, and represented 0.80 percent of average assets in 2003 compared to 0.44 percent in 1990.

Looking forward, we anticipate that mortgage loan refinancing activity will decline from the current high levels, which will dampen loan origination volume and

earnings. The level of new home construction starts and sales of existing homes remain strong, however, providing a potential counterbalance to recent declines in refinancing activity. Although interest rate risk is not an immediate threat for thrift

institutions, OTS continues to closely monitor for changes in interest rate risk.

ASSET QUALITY

The quality of thrift loan portfolios continues to be very good, with key measures

of problem loans relatively low, though up slightly from the historic lows set in

2000. Troubled assets (loans 90 or more days past due, loans in nonaccrual status,

and repossessed assets) represented 0.67 percent of assets at the end of 2003. The

ratio of troubled assets to total assets has remained below 1 percent since September 1997, but is slightly above the recent low of 0.58 percent reported at September 30, 2000.

As might be expected, the level of delinquent loans generally increased through

the duration of the recent economic slowdown. The increase was modest, however,

particularly given the record low levels set in 2000. Moreover, the industry’s noncurrent loan ratio declined in 2003 to 0.58 percent of assets from a post-2000 high of

0.65 percent in December 2002. Less seriously delinquent loans—those 30–89 days

past due—were 0.71 percent of assets as of the end of 2003, slightly lower than the

level (0.74 percent) at the end of 2000. Loans 30–89 days past due have generally

remained at these levels since 2000 despite some quarterly fluctuations.

Loan charge-off rates have risen since 2000, reflecting the modest pace of economic activity. Net charge-offs as a percent of total assets were 0.26 percent in

2003, up from 0.24 percent in 2002 and 2001, and 0.19 percent in 2000. Thrifts’

charge-off rates are typically lower than those of commercial banks since thrift loan

portfolios are heavily concentrated in single-family mortgages. Charge-off rates for

single-family mortgages are generally very low compared to other types of loans.

The charge-off rate on all single-family mortgage loans was just 0.05 percent in

2003, or $50 for each $100,000 in loans.

Thrifts’ provisions for loan losses generally increased in response to the rise in

noncurrent loans and loan charge-offs. Total loan loss provisions were 0.21 percent

of average assets in 2003, 0.30 percent in 2002, and 0.28 percent in 2001—all up

from 0.20 percent in 2000. Increased loan loss provisioning kept the industry’s total

loan loss allowance relatively stable despite increased charge-offs. Total allowances

measured 0.60 percent of assets for 2003, down slightly from 0.64 at the end of

2000. The slight declines in 2003 loan loss provisions and loan loss allowances reflect the improved economic outlook and signs of recovery from the most recent recession.

As real estate financing activity surged in recent years due to historically low interest rates, OTS has monitored housing values across the United States. While

75

3FDIC Outlook, March 2, 2004.

there may be some regional pockets in the United States where a ‘‘bubble’’ could

exist, this does not appear to be a nationwide problem. Because local economic and

demographic factors are the primary influences on home prices, significant home

price declines have occurred historically only in markets experiencing severe economic distress. Given the generally improving economic conditions nationwide, a recent FDIC 3 study concludes, for example, ‘‘that a widespread decline in home prices

appears unlikely, even when mortgage rates begin to rise from current low levels.’’

This is not to say that mortgage lending is not without its risks, especially when

mortgage interest rates rise. For example, highly leveraged borrowers and those in

high-priced home markets tend to rely on adjustable-rate mortgages, making them

vulnerable to interest rate ‘‘shock’’ once short-term interest rates begin to rise. Likewise, home price appreciation may slow as rising mortgage rates make homes less

affordable, especially higher-priced homes.

CAPITAL

Capital measures for the industry are strong, stable, and well in excess of minimum regulatory requirements. While industry growth can often pressure capital ratios, even as industry growth has continued, thrifts have maintained high levels of

capital through prudent earnings retention and receptive capital markets. Equity

capital was 9.1 percent of assets at the end of 2003. Ninety-nine percent of all

thrifts, holding 99.9 percent of industry assets, exceeded the PCA well-capitalized

standards. Although the number of undercapitalized institutions fluctuates over

time, only two thrifts were less than adequately capitalized at the end of 2003. One

of which has since been recapitalized. Consistent with PCA, we are monitoring these

institutions to ensure that management responds aggressively to resolve areas of supervisory concern.

FUNDING SOURCES

The industry has become somewhat more reliant on wholesale funding as deposit

growth slowed due to changing savings and investment patterns and robust competition from mutual funds. Although deposits remain the primary source of funding

for the industry, the ratio of deposits to total assets declined steadily over the past

decade. In 1990, deposits funded 77 percent of thrift assets. By the end of 2003, the

ratio had declined to 58 percent.

With deposit levels declining, the thrift industry has accessed greater levels of

wholesale funding, primarily in the form of Federal Home Loan Bank (FHLB) advances. At the end of 2003, FHLB advances funded 17.4 percent of total thrift assets, up from 7.4 percent in 1991. In addition, other types of borrowings, such as

repurchase agreements, subordinated debt, and Federal funds purchased, funded

11.3 percent of assets, up from 5.5 percent in 1991.

PROBLEM THRIFTS

The number of problem thrifts—those with composite safety and soundness examination ratings of ‘‘4’’ or ‘‘5’’—fluctuates over time but remained low in recent years.

There were eight problem thrifts at the end of 2003—the lowest level since OTS’s

inception. Assets of problem thrifts comprised only 0.1 percent of industry assets at

the close of 2003.

Thrifts assigned a composite ‘‘3’’ rating, while not considered problem institutions,

also warrant more than the normal level of supervisory attention. At the end of

2003, there were 57 thrift institutions assigned a 3 rating, which is unchanged from

the prior quarter and down significantly from 72 one year ago. Of these 57 thrifts,

98 percent were ‘‘well-capitalized,’’ and thus have a capital cushion that increases

their ability to work through difficulties in an orderly manner.

Supervisory attention is also focused on concerns identified at institutions in the

areas of Compliance, Community Reinvestment Act (CRA), and Information Technology (IT). At the end of 2003, there were 46 thrifts rated ‘‘3’’ or below in Compliance, including three thrifts with ‘‘4’’ ratings. Eight thrifts were rated less than

satisfactory in their CRA examinations. Reflecting the rapid changes in technology,

focus on privacy and security concerns, and increased demand for technological expertise, two thrifts were rated ‘‘4’’ or ‘‘5’’ on their IT exam, and 36 thrifts were assigned ‘‘3’’ ratings. In all cases, we initiated prompt supervisory strategies to effect

management corrective actions to address areas of concern. The vast majority of

OTS regulated institutions are in compliance for CRA and IT.

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4 Based on data from the Mortgage Bankers Association of America and Federal Housing Finance Board.

Evolving Role of the Thrift Industry

COMMUNITY LENDERS WITH RESIDENTIAL FOCUS

While thrifts provide a wide variety of loan products, including consumer and

commercial loans, they continue to focus primarily on residential mortgage lending.

Thrifts originated 21 percent of all single-family mortgage loans made in the United

States in 2003. Thrifts are major originators of adjustable rate mortgage (ARM)

loans. In 2003, about one-third (31 percent) of all new ARM’s were originated by

thrifts.4

In 2003, the industry originated $730 billion in single-family mortgages, the highest annual volume on record, exceeding by more than 50 percent the prior record

of $472 billion in 2002. Since 1999, the thrift industry has originated over $2 trillion

in single-family home loans; which, at an average home value of $200,000, represents 10 million homes in America. Single-family mortgage loans and related securities comprised about 62 percent of thrift assets at the close of 2003. Thrifts are

also active lenders for multifamily lending. In 2003, thrifts originated $20.1 billion

in multifamily mortgages. At the end of 2003, thrifts held in portfolio $53.7 billion,

or 4.9 percent of their assets, in multifamily mortgage loans. This brings the percentage of assets held in residential-related loans and securities to 67 percent.

Thrifts also provide vital services to other segments of their communities by making commercial real estate loans to hospitals, nursing homes, farms, churches, and

stores, and on other commercial properties. Such loans comprised 4.3 percent of

thrifts’ assets at the end of 2003.

While thrifts continue to focus on mortgage lending, they have steadily expanded

their product offerings in the areas of consumer and commercial business lending.

The industry’s ratio of consumer loans-to-assets was 6.5 percent at the end of 2003,

up from 4.5 percent at the end of 1990. Utilizing the expanded small business lending authority granted by the Economic Growth and Regulatory Paperwork Reduction Act of 1996, the industry’s ratio of commercial loans-to-assets stood at 3.6

percent at December 31, 2003, up from 1.5 percent at the end of 1997. Based on

our semi-annual subprime lending survey, there were 32 OTS-regulated thrifts with

subprime lending programs as of the end of the third quarter 2003. These thrifts

have formal lending strategies directed to subprime borrowers as opposed to lenders

that may make an occasional loan to a borrower with a low credit score, for example. Aggregate subprime lending for these 32 thrifts increased 11 percent to $14.8

billion at September 2003 from the prior year.

DIVERSIFIED FINANCIAL SERVICES PROVIDERS

In addition to core lending products, thrifts continue to expand the range of savings and investment products offered to their communities. The thrift charter provides an excellent platform with a comprehensive and uniform regulatory structure

that allows for the efficient delivery of a wide range of financial products and services. Thrifts have taken full advantage of the strength of their charter to serve retail

customers both in their local communities and beyond.

The success of thrifts in providing a broad range of financial services is evident

in the industry’s level of trust assets administered, which has risen dramatically

over the past 8 years. The facility of the charter in this area has also attracted a

number of new firms to use the thrift charter as the vehicle for providing these services. For 2003, trust assets administered by the industry totaled $563.5 billion

versus $13.6 billion at the end of 1995.

Risks Facing the Thrift Industry

CREDIT RISK

The thrift industry’s sound financial condition permits it to address potential credit quality problems from a position of strength. Thrift industry credit risk is primarily driven by the performance of residential mortgage loans. Given the current

strength of the housing market in most areas of the country, single-family residential loan delinquencies and charge-offs have remained at low levels.

Future deterioration in any of the fundamentals that affect housing strength, such

as worsening unemployment rates, could adversely affect thrifts’ asset quality. As

community-based lenders, the majority of thrifts’ loans are made to consumers. Direct loans to consumers, including single-family mortgages, measured 55.9 percent

of thrift assets at the end of 2003. Given this concentration, thrifts’ asset quality

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ment and ability to service their debt. We know of no major problems facing us in

either regard.

Thrift credit exposure is not limited to the consumer loan sector. Thrifts are also

exposed to the business sector, with 3.6 percent of thrift assets held in commercial

loans and another 12.0 percent of assets held in construction loans and nonresidential and multifamily mortgage loans. A slowdown in the economic recovery could

pressure the cashflow of commercial borrowers. Alternatively, a strong recovery that

spurs a steep rise in interest rates may also impact commercial borrowers, since

business loans typically carry floating rates of interest. Credits that are highly dependent on low interest costs for positive cashflow would be most vulnerable to

rapid increases in interest rates.

Credit review is a significant priority in our examination process, with the scope

of our review formed by economic trends and expectations. Our analysis shows that

as interest rates rise after a trough, many mortgage lenders lower credit underwriting standards to maintain high loan origination volumes. Such vintages often

significantly underperform other vintages. Consequently, as rates have begun to

rise, OTS examiners have begun focusing even greater attention on thrifts’ underwriting processes, credit quality, reserve policies, and capital adequacy. The loan

monitoring, loan collection, and work-out procedures of thrifts are also receiving increased scrutiny. Our best performing thrifts are diversified and we support the

industry looking for ways to be less reliant on interest income. We emphasize, however, that expanding into new areas requires investment in the right people, systems, internal controls, and internal audits.

INTEREST RATE RISK

OTS closely watches interest rate risk given the thrift industry’s natural concentration in longer-term mortgage loans, which are generally funded with shorterterm deposits and borrowings. Since interest rates typically rise during economic

recoveries, monitoring interest rate risk will be especially important in the upcoming quarters. Interest rate sensitivity can manifest itself in several ways in a rising

rate environment, including a declining value of long-term assets with below market

rates and increased funding rates which tends to compress thrifts’ net interest margin.

OTS maintains an interest rate risk sensitivity model that stress-tests thrift portfolios to evaluate potential exposure to changing interest rates. We are unique in

that regard. OTS regulations also require thrift management to monitor and manage interest rate risk on an ongoing basis and maintain exposure at prudent levels.

With the OTS model and prudent thrift management practices, the industry is wellpositioned to assess and respond to portfolio sensitivity resulting from changes in

interest rates.

As of the end of 2003, under a simulated instantaneous 200 basis point rate

shock, 80 percent of all thrifts were classified as having low levels of interest rate

risk, 15 percent as having moderate levels, and 5 percent as having higher levels

of interest rate risk. These numbers have trended higher the past two quarters because of the tendency of some institutions in a steep yield curve environment for

institutions to invest in long-term assets (for example, 30-year fixed mortgages) and

to fund such investments with short-term liabilities (for example, short-term certificates of deposit and short-term Federal Home Loan Bank advances). Approximately

50 percent of the mortgage instruments held in portfolio by OTS-regulated thrifts

were originated in 2003.

Institutions demonstrating higher levels of interest rate risk receive close supervisory scrutiny. Given that interest rates typically move in a more gradual fashion,

thrift management often has significant opportunity to institute remedial actions to

limit the potential impact of a changing interest rate structure. While the current

interest rate environment and yield curve structure are generally favorable for

thrifts’ operations, the failure to react to rising interest rates that come with economic recovery or changes in the yield curve structure could adversely impact thrift

earnings. We see no major problems in that regard at the current time.

In 2003, many thrifts took advantage of the low rate environment to extend liability maturities at favorable terms. The lengthening of liability maturities provides

a buffer for thrifts against the impact of rising rates. In addition to strategic funding decisions, mortgage loan demand has shifted thrift loan portfolios increasingly

toward holding more fixed-rate loans with shorter-terms (10, 15, and 20 years) than

the traditional 30-year product, and higher levels of adjustable-rate loans and hybrid loan types.

Shorter-term fixed rate mortgages amortize principal more quickly than traditional 30-year loans, which provides thrifts with greater cashflow to invest as rates

rise. Adjustable-rate mortgage rates will reset to higher levels in a rising rate enviVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00081 Fmt 6633 Sfmt 6621 24910.TXT SBANK4 PsN: SBANK4
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ronment. Likewise, hybrid loan products that are fixed for periods of 3, 5, 7, or 10

years and then convert to adjustable rates will reset rates and provide a buffer

against rising rates. Collectively, these asset/liability trends could mitigate some of

the adverse impact that rising rates typically have on thrifts.

Even with the favorable rate environment and strategic thrift asset/liability management, OTS remains cautious of the potential impact of a rapid increase in market interest rates. OTS employs a scenario-based modeling approach, applied on a

quarterly basis, to estimate the potential exposure that thrifts have to various rate

change scenarios. In addition, we require thrift management to monitor interest

rate risk regularly, set appropriate risk limits, and manage potential exposure at

acceptable levels. OTS will remain vigilant in monitoring institutions for adverse

trends and ensuring that thrifts are properly focused on the potential impact of

changing interest rates.

COMPLIANCE RISKS

Compliance risk is another risk that the industry faces and one that OTS also

closely watches. The increased volume of consumer transactions, along with the increase in consumer protection and other regulations governing those transactions,

necessitates an active compliance management function within financial institutions

and in oversight programs within the banking agencies. Certainly in today’s environment, the importance of effective compliance management is elevated by: (1) the

need to ensure the privacy and security of consumer financial information as more

information is shared and outsourced, and as the threat of identity theft persists;

(2) the need to guard against money laundering and terrorist financing activities in

a post-September 11 environment; and (3) the need to stem the tide of abusive lending practices and ensure fair and equal access to credit for all Americans.

As with its management of other risks, OTS, due to recent internal examination

restructuring and enhancements, is now in a stronger, more proactive position than

ever to effectively examine for and address potential compliance problems and risks

within a comprehensive examination context. We are training more examiners in

the area of compliance, we are conducting compliance reviews more frequently, and

we are using a risk-focused approach. The CORE components of all compliance examinations include a review of BSA/USA PATRIOT Act, Privacy and Fair Lending.

Our fundamental examination objective is to ensure that institutions have in

place the resources to support an effective compliance management program that is

commensurate with the size, complexity, and risk profile of the institution. To promote and reinforce full compliance with these critical laws, OTS routinely conducts

in-depth training for OTS examination staff.

INTENSE COMPETITION

Business convergence and continued consolidation in the financial services industry have created an increasingly competitive environment. This stimulates thrift

managers to focus on strategies to improve efficiencies in the delivery of financial

products and services, customize product offerings to meet customer needs, and ensure quality customer service. Some managers may seek to enter new business lines

that are not fully served by the financial community. Subprime lending, whether

home equity or credit cards, is one such business. Well-managed subprime lending,

with responsible marketing, pricing, and terms, is an important element in improving and expanding credit access. We support subprime lending but are vigilant to

assure ourselves that it is not delivered in a predatory manner. Any pattern or practice of predatory lending is immediately criticized and eliminated.

Guiding an institution through lending expansion is, of course, the responsibility

of each institution’s management and board of directors. The willingness of management and directors to understand and manage risk is one of the primary underpinnings of a safe and sound operation. Thrifts must adopt prudent strategies to operate successfully in an increasingly competitive environment. We emphasize to our

examiners and supervisory staff the need to focus on ensuring that thrifts have the

requisite managerial expertise, sound policies and procedures, and adequate systems before entering new lines of business. We also encourage institutions to work

with our examiners and supervisory staff when pursuing new business activities in

order to address problems as they arise and to avoid surprises between examinations. Our best performing thrifts also have strong internal controls and internal

audit procedures.

BUSINESS TRANSITIONING

We are closely monitoring how thrifts transition from the current intensive ‘‘mortgage-banking’’ mode to a more diversified lending environment. In recent periods,

low mortgage rates have spurred refinancings and record origination volumes, and

income from this increased lending has helped boost overall thrift profitability. As

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the economy continues to recover and interest rates rise, lending activity—especially

refinancings—have declined. At the same time, thrift managers will continue to be

pressured by shareholders to maintain current earnings levels despite reduced lending activity. These pressures may include reducing overhead costs to help maintain

earnings or entering into new activities or reaching for greater fee income. While

we expect some industry staff reductions in response to decreased lending volumes,

our examination and supervisory staff will closely evaluate thrifts’ responses to ensure that the quality of loan underwriting and internal controls is not compromised.

We also follow-up with thrift management to ensure that institutions effectively

manage new business lines.

TECHNOLOGY/OPERATIONAL RISKS

Operational risk, including the risk of loss due to technical failures and human

error, seems to be an ever-present concern in the financial services industry. Advances in technology have created new opportunities for thrifts, especially in marketing and broadening customer services. Thrifts also utilize technology to increase

their understanding of certain credits, enabling better product pricing. The growth

of Internet banking, outsourcing of core banking functions, and the rapid pace of

technological and financial innovation creates new challenges and concerns for thrift

management. The use of technology for these purposes is encouraged.

Our IT examiners, and, increasingly, specially trained safety and soundness examiners, focus on how well thrifts’ use of technology is designed and monitored to

minimize operational risk and ensure thrift and customer security and privacy. The

lessons learned from financial difficulties experienced by many ‘‘high tech’’ companies, the widespread power disruptions in the Northeast last summer, and the impact of the September 11 attacks has illustrated the need for contingency planning.

Thrift institutions’ contingency planning, back-up, and recovery programs are receiving increased supervisory attention from our examination and supervisory staff.

OTS Regulatory and Supervisory Focus and Strategies

EARLY DETECTION AND RESOLUTION STRATEGIES

OTS uses regular on-site examinations and quarterly off-site financial monitoring

to identify thrifts that warrant closer supervision. When problem institutions are

identified, OTS acts promptly to ensure thrift management and directors institute

corrective actions to address supervisory concerns. In addition to a host of financial

analytics and early warning systems, two processes that we use to monitor problem

institutions are the Regional Managers Group meetings, which are held 10 times

annually, and quarterly high risk case briefings. These meetings enable senior OTS

staff and regional managers to discuss high risk or high profile institutions regularly throughout the year. The tools are invaluable to share our collective experiences, develop effective supervisory strategies and enhance consistency across the

agency. These processes allow senior Washington staff to closely monitor problem

institutions, while the regions retain primary responsibility for ongoing supervision.

We have refined our off-site monitoring process by increasing early warning systems to help identify adverse industry trends and potential problem areas. We

maintain dedicated financial analysts at our headquarters and in the regions to ensure that off-site tools are maximized. OTS examiners and analysts utilize our Risk

Monitoring System (RMS) to assist off-site financial analysis. This risk identification

model utilizes combinations of financial ratios to identify areas that need prompt

attention and further analysis. The RMS also provides our examiners and analysts

with direct links to thrift websites, thrift stock price data, securities filings, and

general economic information, all used to closely monitor and analyze thrift operations between on-site exams. In addition to the RMS, we operate our Net Portfolio

Value (NPV) model to simulate the potential interest rate risk exposure resulting

from a variety of interest rate shock scenarios.

OTS SUPERVISORY INITIATIVES

Consolidated Examination Structure

Two years ago, OTS began to combine its separate safety and soundness and compliance examinations in order to attain greater efficiencies in its examination process, improve its assessment of risk within the industry, and provide examiners with

broader developmental opportunities. OTS views compliance as a safety and soundness issue. Examination teams have recently begun to conduct joint examinations

and to issue one examination report on both safety and soundness and compliance

matters. OTS is now engaging in a more comprehensive assessment of an institution’s risk profile by examining its compliance with consumer laws and regulations

simultaneously with its prudential supervisory analysis as an integral part of the

evaluation of an institution’s business strategy, and over time, it expects to reduce

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the costs and burden of examinations on institutions. The majority of responses

from institutions has been overwhelmingly favorable.

During this time, safety and soundness and compliance examiners have been actively engaged in an intensive cross-training program to learn the full knowledge

and skills needed to lead melded examinations. OTS continues to maintain a cadre

of compliance experts, however, to assist examination teams in handling complex

compliance matters. In addition, OTS program staff have been working to produce

combined examination procedures, policies, and handbook manuals.

OTS Organizational Changes

Following a major restructuring of regional and field operations in 2002, OTS recently reorganized its Washington supervision oversight operations in order to manage the evolving direction of the thrift industry more effectively. OTS established

three primary entities within a newly structured Office of Examinations, Supervision, and Consumer Protection. The first oversees the most complex institutions

as well as holding companies with significant international operations. A second entity oversees the examination and supervision of all other regulated institutions.

The third oversees all policy development affecting examination and supervision of

institutions’ activities, including capital markets, trust, consumer protection, accounting, and information technology. During the past year, OTS has also begun to

participate on the Basel Committee on Banking Supervision in order to ensure that

pending international capital standards take into consideration the various needs of

thrift institutions. In addition, we are well along the path of securing equivalency

status under the European Union’s (EU) Financial Conglomerates Directive to provide for coordinated, consolidated supervision of thrift holding companies with European operations.

REGULATORY AND SUPERVISORY COORDINATION

Convergence in the financial services markets has been proceeding at a rapid pace

in recent years and will continue as companies attempt to maximize synergies

across business lines. OTS has supervisory responsibility for thrift institutions and

thrift holding companies, many of which engage in insurance and securities activities. These activities are often conducted by multiple legal entities within a corporate structure and across numerous regulatory jurisdictions. Given the scope of

activities in thrifts and thrift holding companies, it is critical that we maintain

healthy relationships with all financial regulators and supervisors.

OTS maintains regular contact with State and Federal functional regulators. Our

goal is to coordinate supervisory activities and knowledge to limit overlapping regulatory efforts, and to identify regulatory gaps that may exist across functionally regulated business sectors. We have also expanded our regulatory contacts abroad to

ensure effective supervision of thrift holding company structures that maintain significant operations in foreign markets.

Functional Regulator Coordination

Domestically, our regional offices have working relationships with insurance and

securities regulators in states where these companies conduct operations. Our coordination activities also involve meetings, regular communications, and joint activities and programs, often through various supervisory coordinating entities such as

the National Association of Insurance Commissioners (NAIC), the National Association of Securities Dealers (NASD), and the North American Securities Administrators Association (NASAA).

We have worked extensively with the NAIC to minimize regulatory overlap as

more insurance companies acquire thrifts. These efforts resulted in the establishment of information sharing agreements with insurance regulators from 47 States

and the District of Columbia. Our activities include shared attendance and participation in official agency programs, conferences, and training seminars. These events

foster cross sector learning and provide opportunities to cultivate regulatory relationships.

OTS staff also coordinates closely with regional counterparts at the NASD to identify issues of common interest involving securities activities by thrift service corporations engaged in securities brokerage activities. Similarly, we have developed

relationships with staff of the NASAA that enable us to coordinate and leverage our

resources to achieve success in areas of mutual interest. We continue to work with

the Securities and Exchange Commission (SEC) on policy matters (such as the privacy regulations required under the Gramm-Leach-Bliley Act) and, when appropriate, on matters involving specific institutions.

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5 As noted below (see Items for Legislative Consideration), OTS is actively seeking membership on the Basel Committee on par with that of the other FBA’s.

FFIEC and Federal/State Cooperation

Domestic and international financial services supervisors know well that supervisory cooperation produces innovative solutions to industry issues and provides invaluable perspective on cross sector trends and risks. OTS works closely with the

other Federal banking agencies (FBA’s) and State bank regulators in various forums

and capacities. For example, in connection with proposed OTS regulations on mutual savings associations and mutual holding companies, we have met with seven

State banking commissioners. The Conference of State Bank Supervisors (CSBS)

was very helpful in arranging these meetings. I currently serve as Chairman of the

Federal Financial Institutions Examination Council (FFIEC), which has significantly increased uniformity among the FBA’s in prescribing principles, standards,

and report forms for examinations and the supervision of financial institutions.

Coordination on the Basel Process

Internationally, although we are not currently a member of the Basel Committee,5

OTS attends—along with the other participating FBA’s—the Basel Committee meetings and participates in key subcommittee meetings and working groups. The international community of financial services supervisors provides an excellent forum to

share experiences and work cooperatively to develop innovative and effective supervisory guidance. Participation in these forums has been critical in understanding

global trends that may impact or threaten thrifts or thrift holding companies.

For example, our involvement in the Basel process has provided us with important insights into the potential domestic impact of the proposed Basel II changes.

In particular, we are concerned that Basel II may be adopted in the United States

before being sufficiently tested to assess its competitive impact. In addition to concerns regarding competitive equity, the Basel discussions and ensuing debate have

highlighted deficiencies regarding the continued application of Basel I to the vast

majority of institutions expected to continue to utilize it.

We are particularly concerned about the safety and soundness implications of

leaving thousands of small- to mid-sized institutions on a less risk sensitive regime

while our largest institutions move to a more risk sensitive system. In such a bifurcated construct, Basel I institutions have an incentive to replace lower-risk assets

with higher-risk assets since their capital requirement is apt to be too high for the

former and too low for the latter, as measured against Basel II institutions. We

therefore believe that FBA efforts and resources should be directed at borrowing

from the lessons learned in Basel II to develop a capital adequacy system—applicable to all but the largest internationally active institutions—that is more risk sensitive than Basel I, but less complex and more accessible than Basel II.

In addition to the international Basel Committee meetings, OTS actively participates in all domestic task force meetings on Basel.

OTS Role as Consolidated Coordinating Supervisor

OTS has engaged in active dialogue with representatives from the EU on matters

relating to the EU’s directive on the supervision of financial conglomerates. The EU

is seeking to ensure that financial conglomerates domiciled outside the EU member

countries are subject to an equivalent level of consolidated supervision by foreign

supervisors and to enhance coordination among relevant supervisors. OTS is the

consolidated supervisor of U.S.-based thrift holding companies, including a number

of financial conglomerates active in the EU. OTS is seeking equivalency status

under the EU’s Financial Conglomerates Directive (FCD).

The FCD requires the designation of an equivalent consolidated supervisor to act

as regulatory coordinator with the relevant EU supervisors. The FCD sets out certain broad review criteria in the areas of risk management and internal controls,

in addition to more specific requirements for the reviews of capital adequacy, risk

concentrations, and intragroup transactions. OTS has the regulatory authority and

supervisory processes in place to collect relevant information and conduct the necessary supervisory reviews.

OTS has initiated dialogue with several foreign supervisors to determine the

scope of their interest thrift holding company activities. We will continue to work

closely with relevant EU supervisors to ensure that there are no underlaps or overlaps in the supervision of thrift holding companies that are deemed to be conglomerates under the FCD.

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Items for Legislative Consideration

Among the factors that have contributed to the health and profitability of the

thrift industry is a vibrant, flexible and dynamic community banking charter. I believe that the thrift charter is the preeminent community retail lending charter. It

promotes homeownership while serving the diverse financial needs of retail customers in communities across America. Not only is it a charter worth preserving,

but also worth improving. We have identified numerous areas that warrant legislative consideration to improve the thrift charter by reducing regulatory burden and

improving OTS supervisory authority. Principal among these are the following:

• Eliminating the disparate treatment of thrifts under the Federal securities laws.

This includes eliminating the investment adviser and broker-dealer registration

requirements that apply to thrifts, but not banks, under the Investment Advisers

Act (IAA) and the Securities Exchange Act of 1934 (1934 Act). • Amending the International Lending Supervision Act (ILSA) to support adding

OTS to the Basel Committee. This includes extending ILSA to thrifts to promote

consistency in supervising the foreign activities of insured institutions. • Enhancing the ability of Federal thrifts to make small business and other commercial loans by increasing the percentage of assets limitations on these categories of lending. This will enhance the ability of thrifts to contribute to economic

recovery and provide small and medium-sized businesses greater choice and flexibility in meeting their credit needs. Specifically, we support raising thrifts’ aggregate commercial lending limit from 20 percent to 40 percent of assets, and modifying the sub-cap for commercial lending other than small business lending from

10 percent to 20 percent of assets. • We also urge increasing the $250 million small institution 18-month examination

exception up to $500 million.

We look forward to working with you and your staff on these and any other legislative items that you want to address.

Conclusion

The thrift industry has grown and diversified over the past several years while

reporting excellent financial results. Thrifts continue to play a vital role in providing

mortgage funding and other retail products and services to their communities. At

OTS, we will continue to evaluate our policies, staffing, and infrastructure to ensure

that the agency is well-prepared to handle new or emerging risks. We strive to provide the appropriate level of supervisory support to the institutions we regulate

through guidance, industry training, and regular communications. We are confident

the industry will continue to fulfill its primary focus of serving retail customers with

mortgage funding and other financial services in a profitable and prudent manner.

—————

PREPARED STATEMENT OF DENNIS DOLLAR

CHAIRMAN, NATIONAL CREDIT UNION ADMINISTRATION

APRIL 20, 2004

Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee,

thank you for the invitation to testify before you today on behalf of the National

Credit Union Administration (NCUA) regarding the condition of the credit union industry in America and the National Credit Union Share Insurance Fund (NCUSIF)

that insures the deposits of credit union members nationwide.

Condition of the Credit Union Industry

I am pleased to report to the Committee that the state of the credit union industry remains strong and healthy with all indicators clearly portraying a safe and

sound industry serving over 82 million Americans and well-positioned for continued

strength and vitality in our Nation’s financial marketplace, both now and in the future.

At this point I would like to provide a brief discussion of key ratios and trends

compiled from call report data submitted to NCUA by all federally insured credit

unions as of December 31, 2003.

• The average net worth-to-assets ratio of all federally insured credit unions remains extremely strong at 10.72 percent, even though there has been significant

share growth of 15.27 percent in 2001, 10.77 percent in 2002, and 9.11 percent

in 2003. Such a strong share deposit growth would normally bring about a significant decrease in the net worth ratio were not the credit unions managing these

increased shares effectively and continuing to build net worth. For example, over

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the course of 2003, credit union net worth, which is built solely from the retained

earnings of the credit union, has increased in total dollars by 9.57 percent. This

growth in actual dollars of net worth results in the highest level in history of total

industry net worth, currently at $65.4 billion as of December 31, 2003.

• Return on average assets (ROA) is 0.99 percent which, even with a historically

high growth in shares during a low interest rate environment, compares favorably

with recent historical trends (1.07 percent in 2002 and 0.94 percent in 2001).

• Asset growth was 9.52 percent and share growth was 9.11 percent in 2003.

• Loan growth was 9.75 percent in 2003. Over the course of 2003, share growth

slowed and loan growth increased, resulting in a loan-to-share ratio of 71.2 percent, compared to 70.8 percent in 2002 and 79.5 percent in 2000. Total loans to

credit union members totaled $376.1 billion, up $104.5 billion since year-end 1999.

• Credit unions’ overall delinquency ratio remains steady at 0.77 percent and is

slightly lower than the ratios recorded in the previous 2 years (0.80 percent in

2002 and 0.82 percent in 2001), thus demonstrating effective risk management in

the loan portfolios during a period of economic downturn in many industries and

communities.

• Savings grew to $528.3 billion in 2003, an increase of 9.11 percent. Despite the

increases in lending indicated earlier, much of these increased savings are being

placed in the conservative investment options available to credit unions under applicable Federal and State laws and regulations. Investments in Federal agency

securities grew 18.6 percent in 2003. Funds deposited in corporate credit unions

grew 9.4 percent during the same period, and investments in banks, savings and

loans, and savings banks expanded 12.3 percent.

• Total assets grew to an all-time high of $610.2 billion, an increase of 9.52 percent.

• Member business lending in credit unions increased by 32.9 percent to $8.87 billion. Although this category of credit union lending has increased over the past

year, member business lending still represents only 2.36 percent of all loans in

federally insured credit unions.

• First mortgage real estate loans grew 16.63 percent to $117.5 billion, thus continuing the growth of credit unions as a source of access to the American Dream

of homeownership for millions of their members.

• New auto lending increased 5.47 percent in 2003. Reflecting both economic trends

and market considerations, used auto loans increased by 12.51 percent to $81.2

billion.

The ratios and trends presented above are not unexpected in the present economic

and marketplace environment; however, taken as a whole, they are indeed indicative of a healthy and robust industry.

Emerging Risks and Challenges for the Industry

NCUA is closely monitoring a number of key issues and trends specifically affecting the credit union industry, as well as those related to the overall financial marketplace. The following issues are among those we have been closely monitoring:

Interest Rate Risk and Net Margin Compression

Loan growth continues to be concentrated in fixed rate real estate loans being

granted at the lowest rates in 40 years. In 2003, total real estate loans grew 13.9

percent and accounted for 44.6 percent of loans outstanding. At the same time,

shares grew 9.11 percent, with growth concentrated in short-term, liquid accounts.

The combination of high growth in fixed rate real estate loans and volatile, nonmaturity shares poses potential risk management challenges to credit unions, while

also providing unique member service opportunities. If the economy continues to improve, equity market investing increases, consumer borrowing demand returns and

interest rates rise, meaning potential interest rate risk, liquidity risk, credit risk,

and earnings risk may increase, as well.

While the volume of first mortgage loan originations has increased, so has the

percentage of first mortgages sold, increasing from 29.2 percent in 2000 to 43.1 percent as of December 2003. Credit unions sold $37.4 billion in first mortgages in the

secondary market in 2003, compared to $25 billion in 2002. This indicates credit

unions are appropriately managing, recognizing, and responding to the potential interest rate risk posed by these assets.

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To address the potential risks associated with high concentrations of fixed real estate loans held in portfolio, NCUA issued a Letter to Credit Unions in September

2003 to highlight these trends and to emphasize the need for prudent and diligent

balance sheet management. In addition, NCUA continues to effectively utilize its regional capital market specialists to assist credit unions and examiners alike and to

offer ongoing training and guidance to field examiners to address these risks from

a safety and soundness perspective.

The low interest rate environment likewise has resulted in compressed net interest margins for credit unions. This provides an increased likelihood for credit unions

to consider moving out further on the yield curve to maintain net income levels. Interest rate risk and net margin compression in credit unions remain an oversight

priority at NCUA and will continue to be closely monitored.

Increased Competition for Consumer Lending

As mentioned earlier, the level of consumer borrowing has slowed somewhat in

favor of real estate lending with credit unions continuing to search for new and innovative solutions to serve their members and to retain market share. To remain

competitive for consumer loans some credit unions rely on indirect or third party

lending which could result in potential risks from third party transactions if not

managed properly. In a November 2001 Letter to Credit Unions, NCUA provided

guidance on the level and degree of due diligence that should be exercised by credit

unions when dealing with third party service providers.

Information Systems and Technology Risks

Today more than half of all federally insured credit unions (5,106, representing

54 percent of all federally insured credit unions) have websites with approximately

1,100 more credit unions planning to implement sites in the future. As of December

2003, 15.1 million credit union members conduct transactions via the Internet, up

from 5.6 million as of December 2000.

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While credit unions are implementing new websites, the number and type of electronic services provided has grown steadily with considerable potential for additional growth. Potential transaction risk continues to increase as more credit unions

move to transactional websites and increasingly complex e-commerce services.

NCUA is fully committed to ensuring credit unions are properly prepared to safely

integrate financial services and emerging technology in order to meet the changing

needs of their members. NCUA implemented its Information Systems & Technology

Examination Program (ISTEP) in fiscal year 2000. ISTEP represents a multiprong

approach for identifying, measuring, and mitigating risks associated with information systems and technology (IS&T). This approach includes credit union IS&T examinations, credit union vendor reviews and examinations (NCUA and FFIEC), specialized IS&T examiner training and credit union guidance. Ongoing and further

IS&T initiatives are outlined in greater detail in NCUA’s strategic plan.

Corporate Credit Union Trends

There are currently 30 retail corporate credit unions and one wholesale corporate

credit union. Assets for all corporate credit unions total $108.9 billion. Retained

earnings equal $2.354 billion with a retained earnings ratio of 2.19 percent. The

core capital ratio is 2.95 percent and the total capital ratio equals 6.46 percent.

These numbers reflect activity through December 31, 2003.

Based upon the savings growth trends indicated earlier for natural person credit

unions, corporate credit unions have found themselves flush with excess liquidity for

the past 3 years. Since October 2000, when total assets were at a low of $53 billion,

many corporate credit unions have seen their balance sheets double in size. The

highest asset level was reported in May 2003, when total assets exceeded $126 billion. Total assets have been fluctuating, but have consistently remained over $95

billion since March 2002. The liquidity trend in corporate credit unions coincides

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with consumer confidence in the economy. The flight to safety among investors has

resulted in increased deposits in natural person credit unions. Many of these credit

unions, seeking a safe place for their excess liquidity, are passing the deposits on

to the corporate credit unions.

The high levels of liquidity in the corporate system continue to have a significant

impact on the various capital ratios. Even if liquidity should begin to flow out of

the system, it will take time for the ratios to recover as they are based on 12-month

moving daily average net assets (moving DANA) rather than month-end assets.

Key Issues Facing Corporate Credit Unions

Increased Competition: NCUA expects a continued competitive environment

among corporate credit unions. Corporate credit unions that have increased expenses due to expanded authority infrastructure acquisitions or the purchase of expensive item processing/imaging equipment will find it necessary to increase service

volume to remain profitable. The increased volume will most likely come through

marketing their services to credit unions outside their traditional service areas. The

corporate credit unions that lose members to their competitors will have to decide

whether to enhance their operations so they can also offer more complex products

and services, focus on a niche product or service they can offer at a reasonable price

or consider a viable merger partner. Conversely, the impact of competition may be

somewhat softened as a number of corporate credit unions are looking at strategic

alliances and partnerships as a means of offering some products and services.

Net Worth/ALM: Corporate credit unions have found it increasingly challenging

to remain profitable while maintaining a low-risk, highly liquid balance sheet. Economic and competitive factors will continue to put pressure on corporates to seek

additional yield wherever possible. NCUA will continue to monitor corporate credit

union modeling policies and procedures to ensure the information and reports produced provide reasonable information for decisionmakers of corporate credit unions.

Condition of the National Credit Union Share Insurance Fund

The NCUSIF provides Federal share insurance coverage on credit union accounts

generally up to $100,000 per member in a single federally insured credit union. As

with FDIC coverage of deposits in banks and thrifts, depending upon the structure

of the accounts, there is an opportunity to structure separate account coverage

under the NCUSIF based on the number and nature of the accounts established.

As of December 31, 2003, there were $479 billion in insured funds covered by the

$6.163 billion NCUSIF, with a 1.27 percent equity ratio. At the end of the first

quarter of 2004, the equity ratio in the NCUSIF was 1.29 percent.

Under the Federal Credit Union Act (FCUA), the NCUA Board has the authority

to determine the annual operating level of the fund between the statutorily prescribed parameters of 1.2 and 1.5 percent. This year, as in the last several years,

the Board has set the operating level at 1.3 percent. If, at the end of the calendar

year, the NCUSIF equity level is above 1.3 percent, the Board may declare a dividend. If it is below 1.3 percent, the Board may assess a premium. If the equity ratio

falls below 1.2 percent, the FCUA requires a premium to be assessed. However,

based upon the limited number of losses in federally insured credit unions, history

has proven that in most years the fund level can be maintained without the assessment of a premium through the combination of the 1 percent of insured funds required deposit plus earnings on those deposits.

Since the NCUSIF was capitalized in 1985, only one insurance premium has been

assessed. That single premium assessment took place in 1992 when the problems

in New England area credit unions and in the real estate markets resulted in significant losses to the NCUSIF. Other than in that extraordinary situation, no

premium assessments have been required. In fact, to the contrary, effective management of the NCUSIF and minimal credit union losses has resulted in the end-ofyear equity ratio being above the required operating level in an amount sufficient

to allow the NCUA Board to declare dividends to insured credit unions for six consecutive years beginning in 1995. Due to the high rate of share growth in 2001 and

2002 during a period of declining earnings on the investments of the NCUSIF, the

fund ended the year just below the 1.3 percent operating level and dividends were

not paid in those years. This was also the case for 2003.

There are two primary factors influencing the NCUSIF and its equity ratio at this

time. First, the low interest rate environment of recent years has reduced the investment income to the NCUSIF. In December 2003, gross income was $10.6 million, while in December 2002 gross income was $16.2 million. Investment earnings

have been significantly reduced since many of the fund’s older investments which

yielded over 6 percent have matured over the past several years. The funds are now

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cent. During this same period, the yield of the NCUSIF has fallen over 300 basis

points to 2.02 percent for December 31, 2003.

Second, in July 2002 the NCUA Board adopted a policy of building its reserves for losses to the NCUSIF by transferring $1.5 million a month to the reserve account for incurred losses not specifically identified, in addition to reserves for specific cases and a pool for CAMEL Code 4/5 credit unions. The final $1.5 million

transfer was made as of December 31, 2003 to the reserve account for incurred

losses not specifically identified.

Earnings on the fund principal have been sufficient to keep the NCUSIF appropriately funded into the future absent extraordinary losses, but dividends to insured

credit unions that are allowable by statute when the fund equity level exceeds the

established operating level are not likely to return until interest rates rise sufficiently to allow earnings to return to historical levels.

Losses are anticipated to remain low and extraordinary losses are not anticipated

based upon the ongoing examination and supervision of the credit unions NCUA

regulates and insures.

As of December 31, 2003, there were 217 problem credit unions coded CAMEL 4

or 5. Of the 217, only 10 are coded CAMEL 5. This number has remained quite constant over the last 4 years. For purposes of comparison, there were 338 problem

credit unions in 1999 and, for a 10-year indication, there were 319 in 1994.

For 2003, NCUA was called upon to provide assistance to liquidate, merge or arrange a purchase and assumption for 13 federally insured credit unions. This number is trending lower than in the past 10 years when we averaged 27.8 such cases

per year.

Agency Initiatives

Over the course of the last 3 years, NCUA has taken several initiatives to help

the agency address a rapidly changing and dynamic financial marketplace as well

as bring more efficiency, accountability, and productivity to agency operations.

These initiatives have been influenced by several factors. The overall number of

credit unions is declining while assets and credit union membership are continuing

to grow at record pace. Credit unions are becoming more complex and sophisticated

as technology and member demands change and emerge. Economies of scale and

availability of resources are likewise impacting the level and types of services offered. In recognition of these and other factors, the agency has taken a number of

specific measures to address this changing financial and regulatory environment.

In 2002, NCUA fully implemented a risk-focused examination program in conjunction with a system of risk-based scheduling of examinations. This change in examination emphasis and focus required an agency-wide effort to redesign and update

the call report as well as other computer and informational system enhancements.

In addition, NCUA embarked upon an aggressive and thoroughly enhanced training

program for our field examiners, their supervisors, all regional office staff, and central office personnel in an effort to maximize productivity and to ensure the overall

safety and soundness of the program. As a result of the risk-focused examination

program, agency resources are now geared more than ever toward institutions and

areas of risk requiring the most attention. Likewise, this approach permits examiners to direct their attention to areas of institutional risk and allows them to spend

less time on issues presenting minimal or no risk to the credit union and the insurance fund. Risk-based scheduling of examinations has also provided NCUA flexibility to direct more of its resources to those institutions requiring additional supervision according to their individual risk factors while at the same time maintaining

integrity in our first and foremost mission of ensuring safety and soundness. Not

only has the program allowed NCUA to focus on true areas of risk, but it also has

resulted in more efficient use of agency resources with fewer employees than were

employed by NCUA 10 years ago.

A key component of the risk-focused examination program was the NCUA Board’s

action to require the submission of quarterly call reports, known as 5300 reports,

from all federally insured credit unions. Previously only credit unions over $50 million in assets were required to submit quarterly call reports. All other credit unions

(79.8 percent of the 9,369 federally insured credit unions have less than $50 million

in assets) were only required to submit call reports on a semi-annual basis. However, for the risk-focused examination program and risk-based scheduling to be

effective and to properly monitor and identify areas of risk, NCUA felt it was necessary to require quarterly call reports from all federally insured credit unions so

that the agency, and the State supervisory authority in the case of State-chartered,

federally insured credit unions, could have the most current financial information

available for analysis and review. In an effort to prevent unnecessary regulatory

burden, a short form 5300 report was devised for the smallest credit unions with

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less than $10 million in assets for the interim first and third quarter reports. Call

report data is analyzed and a financial performance report (FPR) is produced for

every federally insured credit union, serving as the basis for ongoing risk analysis.

Another component of the risk-focused examination program involves the designation of subject matter examiners. When areas with a greater opportunity for loss

are identified, the risk-focused examination program relies upon staff to act as brokers for problem resolution. The increasing complexity of credit union operations

and the advanced knowledge necessary to properly identify risk in some areas have

made it increasingly difficult for a generalist examiner to resolve problems without

more extensive knowledge and skills. Therefore, NCUA has developed an examiner

structure where experienced examiners are designated and trained in a specific subject area of concentration such as IS&T and specialized lending. To further enhance

the agency’s examination program, NCUA is studying the creation of a large credit

union examination specialty program based upon a pilot program now concluding.

These programs are intended to ensure the necessary expertise is available to accomplish the more demanding examination skills required when examining more

complex or larger institutions. By focusing staff development in certain areas,

NCUA is able to accelerate the effective evaluations of technical subjects and maintain a current level of knowledge during periods of rapid industry development. This

revised examiner structure will ensure that the sufficient skills and resources are

available to timely identify and limit potential risk to NCUSIF.

Beginning in 2001, NCUA initiated an internal agency self-study, known as the

Accountability In Management (AIM) study, whereby agency management personnel

were tasked with identifying potential areas of NCUA’s internal operations where

cost savings and greater efficiency and productivity could be realized within the

strategic goals of the agency without sacrificing the safety and soundness of the

credit union industry. This in-depth process was finalized over a 2-year period in

two phases with the first portion focusing on the central office and the second phase

focusing on the regional offices. The results of this process have been extremely

positive both for agency effectiveness and efficiency. The overwhelming majority of

the AIM recommendations have been implemented and others are presently in the

process of implementation with a timetable of being fully implemented by the end

of 2004.

One of the most significant recommendations stemming from the AIM study was

the realignment and reduction of NCUA’s regional offices from 6 to 5. Realignment

has been accomplished, and in January 2004 one of NCUA’s six regional offices

closed while another regional office moved to a lower-cost area. This consolidation,

along with the restructuring of several offices in both central and regional offices,

is expected to save the agency and its stakeholders $27 million over the next 10

years. Additionally, as part of this internal initiative, agency staffing levels have

been reduced by 58 FTE’s over the last 2 years without any adverse impact on the

agency’s safety and soundness responsibilities. All of the AIM staffing reductions

were accomplished through attrition and without layoffs, forced retirements, or costly buyouts.

The NCUA Board has successfully implemented a number of regulations and updates that are consistent with the spirit and requirements of the Federal Credit

Union Act as amended by passage of the Credit Union Membership Access Act of

1998 and are resulting in stronger, safer, and sounder credit unions. These updates

in areas such as field of membership, investment options, and member business

lending, among others, have served to provide Federal credit unions with much

needed diversification options required to remain competitive and financially strong

in a constantly changing and rapidly evolving financial marketplace.

Among the more notable initiatives undertaken by NCUA has been the successful

Access Across America program which is designed to create economic empowerment

for people from all walks of life, particularly those residing in underserved or

unbanked neighborhoods and communities. This initiative has seen impressive results as 494 Federal credit unions across the United States have voluntarily adopted

over 1,021 CDFI-designated investment or underserved areas into their fields of

membership since the beginning of 2000. As a result of their expanding into underserved areas, credit unions are required to be financially able to extend services to

the entirety of the community, have an acceptable business and marketing plan to

do so and establish a physical presence in the community. The result has been the

extension of access to affordable financial services and products to over 64.7 million

Americans residing in underserved communities who previously lacked access to a

not-for-profit, member-owned credit union as a alternative source of lower cost financial services in their local neighborhoods—neighborhoods which have become the

home of countless higher cost lenders such as pawn shops, rent-to-own centers,

check cashing outlets, and title loan companies.

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NCUA call report data indicates that the 494 Federal credit unions adding underserved areas to their field of membership since 2000 have grown their membership

at an annual rate of 4.36 percent, which is 237 percent greater than the annual

membership growth rate of 1.29 percent for Federal credit unions overall during the

same 4-year period. Lending growth increased at an annual rate of 12.5 percent in

those Federal credit unions adopting underserved areas, and savings growth has increased 13.5 percent annually. These loan and savings rates are 58 percent and 30

percent higher than the respective growth rates of these two categories in the Federal credit union community as a whole.

Recommended Regulatory Reforms

In response to a request from Chairman Shelby, and on behalf of the Board of

the National Credit Union Administration, I provided the Committee in June 2003

with seven specific recommendations to address unnecessary regulatory burden, improve productivity and other needed regulatory reforms for Federal credit unions.

It is my understanding that each of my colleagues from Federal financial regulatory

agencies represented here today likewise made their own recommendations in response to your letter. We are pleased that these regulatory relief issues, among others, are being evaluated for possible inclusion in legislation this Congress.

The addendum to this testimony describes NCUA’s proposals and the reasons for

them. These proposals are consistent with the mission of credit unions and the principles of safety and soundness. They address statutory restrictions that now act to

frustrate the delivery of financial services because of technological advances, current

public policy priorities or market conditions.

I would encourage the Committee to give serious consideration to NCUA’s regulatory relief recommendations. As always, NCUA stands ready to work as a resource

to the Committee on these and other matters impacting the delivery of financial

services through and the safety and soundness of America’s credit unions.

Conclusion

Again, thank you, Mr. Chairman, for the opportunity to appear before you today

on behalf of NCUA and my colleagues on the NCUA Board to discuss the state of

the American credit union industry. I will be more than pleased to respond to any

questions the Committee may have or to be a source of any additional information

you may require.

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PREPARED STATEMENT OF KEVIN P. LAVENDER

COMMISSIONER, TENNESSEE DEPARTMENT OF FINANCIAL INSTITUTIONS

ON BEHALF OF THE

CONFERENCE OF STATE BANK SUPERVISORS

APRIL 20, 2004

Good morning, Chairman Shelby, Senator Sarbanes, and Members of the Committee. I am Kevin Lavender, Commissioner of Financial Institutions for the State

of Tennessee, and Chairman of the Regulatory Committee of the Conference of State

Bank Supervisors (CSBS). Thank you for inviting CSBS to testify on the condition

of the State banking system.

CSBS is the professional association of State officials who charter, regulate, and

supervise the Nation’s approximately 6,400 State-chartered commercial and savings

banks, and nearly 400 State-licensed foreign banking offices nationwide.

CSBS gives State bank supervisors a national forum to coordinate, communicate,

advocate, and educate on behalf of the State banking system. We especially appreciate this opportunity to discuss the state of our Nation’s banking system in general,

and the state of the State banking system in particular.

Condition of the Industry

As you have heard from my colleagues on this panel, the general health of the

banking industry is excellent. State-chartered banks, which make up approximately

three-quarters of the Nation’s commercial banks, have shared in the industry’s

record levels of prosperity.

Net income of State-chartered commercial and savings banks at year-end 2003

reached $44.2 billion, an 18 percent increase over the previous year’s record levels.

State banks’ aggregate equity capital ratio stands above 9 percent, a level that exceeds the industry aggregate and regulatory requirements, and has risen steadily

over the past 3 years. State banks’ core capital, or leverage ratios, are equally

strong, and slightly higher than those of their federally chartered counterparts.

State banks’ ratio of nonperforming assets to assets continues to decline, and stands

even lower than the industry’s overall level.

As regulators, we look for areas of concern, but even some of these areas have

shown improvement over the last several quarters. We saw deposits in State-chartered banks grow from year-end 2001 to 2002, and again from year-end 2002 to

2003. And our banks are still finding good loans to make, and we saw strong growth

in earning assets in 2003.

We never forget that these record levels of prosperity are occurring in an environment of historically low interest rates, and examiners pay special attention to the

vulnerability of our banks’ portfolios to interest rate volatility. My colleagues and

I have also been particularly concerned about banks’ internal controls systems, because experience has shown us that nothing disguises bad management as well as

a good economy.

Consolidation of the banking industry continues, raising concern about concentration of risk and the range of meaningful choices available to consumers. The pace

of consolidation slowed in 2003, but consolidations continue among the very largest

institutions. The Nation’s 50 largest banks now hold almost 63 percent of banking

assets nationwide. In Tennessee, the six largest banks hold more than 50 percent

of local banking assets; this percentage jumps to more than 80 percent in Davidson

County, the area around Nashville.

We expected consolidation in the wake of the Riegle-Neal Interstate Banking and

Branching Efficiency Act. Consolidation has benefited not only the institutions involved, but also customers who live and work in more than one State or metropolitan area. In some cases, though not all, consolidation seems to have led to lower

costs for consumers and more convenient access to services.

My colleagues and I worry, however, about declining diversity in our banking system, and about the forces driving this latest round of consolidation. I will discuss

these concerns at greater length later in my testimony.

The number of State-chartered banks declined by just over 1 percent in 2003,

compared with a consolidation rate of just over 2 percent in 2002. A steady stream

of new bank charters and conversions has partially offset the number of institutions

lost to mergers over the past several years. Of the 117 new banks chartered last

year, 100 chose a State charter. This rate—85 percent—shows that the banking industry and the business community continue to believe in the value of the State

charter. Ten years after the enactment of the Riegle-Neal Interstate Branching Efficiency Act, the State banking system remains a vibrant and essential part of our

Nation’s financial services infrastructure.

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State-chartered banks make up just over 74 percent of all commercial banks nationwide. They tend to be smaller than national banks, holding in the aggregate just

under 44 percent of U.S. banking assets.

The State system does, however, include several large and complex institutions

that operate across State lines. Over the past 10 years, State banking departments

have worked with the FDIC and the Federal Reserve, as well as other relevant

State and Federal regulators, to develop a seamless supervisory system that ensures

oversight while minimizing supervisory burden. This system continues to evolve.

Our Nation’s financial system—and our Nation’s financial services policies—have

always emphasized the need for balance, diversity, and opportunity. Americans have

traditionally been wary of monolithic authority in any form, whether it is a single

oppressive ruler or one gigantic corporation. Chairman Greenspan has noted on

many occasions that the diversification of our financial system has been an essential

element in preventing the kind of lingering crises we have seen in Asia and Europe.

Our State banking system encourages entrepreneurship in the banking industry,

creating opportunities for new credit providers to enter the market and find new

ways to serve their communities.

As we have seen time and time again, however, not only in the banking industry

but also in the business world at large, even the most entrepreneurial environment

needs oversight, especially when public confidence is at stake.

The State banking departments supervise and regulate a wide range of financial

businesses in addition to commercial banks and savings banks. Most State banking

departments, including my own, supervise State-chartered credit unions as well as

thousands of nondepository financial businesses.

The Tennessee Department of Financial Institutions, for example, licenses and supervises 749 industrial loan and thrift offices, 63 insurance premium finance companies, 1,287 mortgage companies, 390 check cashers, 1,196 deferred presentment

services companies (payday lenders), and 42 money transmitters, as well as 159

State-chartered banks, 10 trust companies, two Business Investment Development

Companies, and 129 State-chartered credit unions.

Our mission is to provide the citizens of Tennessee with a sound system of Statechartered financial institutions. We do this by monitoring compliance with the State

laws and regulations that promote sound business practices and safeguard depositors and consumers. We conduct onsite examinations not only of our depository

institutions, but also of our nondepository licensees. An entire division of our department was recently formed and is dedicated to consumer resources; in fact, the

department resolved 500 complaints in 2003.

Senators, State banks in Tennessee and nationwide are healthy. The State banking system, however, faces a grave threat, and I ask your help in restoring the balance that makes it possible for my department to fulfill its mission.

Role of Preemption in Maintaining the Health of the Banking System

The balance between Federal and State authority over banking activities, and between large and small institutions in the marketplace, continues to evolve. If nearly

140 years of history have shown us anything, it is that the health of the American

banking system depends on competition and meaningful choice: The availability of

a wide range of options for both consumers and financial institutions.

The Conference of State Bank Supervisors is committed to maintaining the competition and choice that have characterized our dual banking system. Competition

and choice in our banking system remain strong despite the industry’s consolidation,

and the availability of the State charter is crucial to this balance. The largest institutions can and should grow to serve their customers and reach new competitive

levels in a global market. As big institutions become even bigger, de novo chartering—again, primarily at the State level—continues to guarantee local banking

options to all consumers. Even in this global economy, it remains true that one size

does not fit all.

A key element of this dynamic balance is the question of Federal preemption of

State authority. My colleagues and I believe that Federal preemption can be appropriate, even necessary, when genuinely required for consumer protection and competitive opportunity.

Few matters of Federal preemption meet this high standard. One that does is the

permanent extension of the amendments to the Fair Credit Reporting Act, which we

congratulate you on enacting last year. The CSBS Board of Directors determined

that these amendments served the national interest, and we applaud the careful

consideration that both houses gave that legislation.

Many State banking departments and other State agencies have consumer protection mandates that they take just as seriously as their Federal counterparts do. As

Securities and Exchange Commission Chairman William Donaldson has noted, FedVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00103 Fmt 6633 Sfmt 6621 24910.TXT SBANK4 PsN: SBANK4
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eral authorities ‘‘cannot be everywhere.’’ Our State-level consumer protection initiatives serve the public interest in their own right, but also complement Federal law

enforcement efforts in a very important way.

Many of the nondepository financial businesses that my office licenses have some

affiliation with a larger, deposit-taking financial institution. In the wake of the

Comptroller of the Currency’s recently promulgated rules that preempt Tennessee

authority over operating subsidiaries of national banks, these businesses have a

powerful incentive to change their corporate structure for no reason other than to

escape state oversight.

The Comptroller of the Currency’s recent regulations preempt almost all State

laws that apply to these businesses, if they are operating subsidiaries of national

banks. This regulation also tries to shield all national banks—and their operating

subsidiaries—from oversight, inspection, and enforcement actions by any State authority, including the State attorneys general.

The Comptroller has said repeatedly that these new regulations present no fundamental shift in the OCC’s roles or responsibilities. He has called these regulations

merely the next logical step in the OCC’s interpretation of the National Bank Act,

the Riegle-Neal Interstate Banking and Branching Efficiency Act, and GrammLeach-Bliley. The Comptroller has also said that these changes are incremental in

nature and unlikely to have major effects on the banking industry or on consumers’

experiences with financial institutions.

These claims are simply not true. These regulations are not minor or incremental

changes. Their scope is nearly unlimited, and their implications are potentially enormous. These regulations exceed the OCC’s statutory authority and disregard Congressional intent. They effectively discard the oversight and consumer protection

structure already in place for these businesses, and they ignore Congress’s design

for functional regulation.

The OCC adopted these regulations over the strong objections of CSBS, the National Governors Association, the National Conference of State Legislatures and all

50 State attorneys general. The OCC also ignored requests from Members of Congress for extra time to consider their implications. Instead, the OCC issued a set

of regulations that will affect millions of consumers across the country without a

public hearing and without meaningful consultation with the parties these regulations would affect. We object strongly to the OCC’s process in issuing these regulations, and we look forward to the findings of the General Accounting Office’s study

of this process.

Technology is changing the delivery of financial products. Many large banks and

some small banks look less like the old commercial bank and more like the diversified financial services providers envisioned by the Gramm-Leach-Bliley Act. We

appreciate that the largest financial services providers want more coordinated regulation that helps them create a nationwide financial marketplace. These goals are

understandable. The State of Tennessee and CSBS support coordinated regulation

in order to promote modernization of financial services, healthy competition among

providers, and greater availability of financial services to the public.

The OCC’s new regulations, however, usurp the powers of the Congress, stifle

States’ efforts to protect their citizens, and threaten not only the dual banking system but also public confidence in our financial services industry. They challenge the

functional regulatory structure created by Gramm-Leach-Bliley and set the Office

of the Comptroller of the Currency as the Nation’s dominant regulator of financial

institutions. They also seem to encourage consolidation among our largest institutions, concentrating financial risk in a handful of gigantic institutions that may become—if they are not already—not only too big to fail, but also too big to supervise

effectively.

Importance of Decentralized Supervision

Maintaining a local role in consumer protection and a strong State banking system is more important than ever in the wake of the current round of mergers among

our Nation’s largest financial institutions. These mergers make economic sense for

the institutions involved, and may offer the customers of these institutions a larger

menu of products and services at prices that reflect economies of scale. But the

strength of our banking system is its diversity—the fact that we have enough financial institutions, of enough different sizes and specialties, to meet the needs of the

world’s most diverse economy. Centralizing authority or financial power in one agency, or in a small group of narrowly regulated institutions, would threaten the dynamic nature of our economy.

State supervision and regulation are essential to our decentralized system. State

bank examiners are often the first to identify and address economic problems, including cases of consumer abuse. We are the first responders to almost any problem

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in the financial system, from downturns in local industry or real estate markets to

the emergence of scams that prey on senior citizens. We can and do respond to these

problems much more quickly than the Federal Government.

The Comptroller has argued that the laws and rules States have enacted to protect their citizens are burdensome to national banks. We are sensitive to regulatory

burden, and constantly look for ways to simplify and streamline compliance. Your

own efforts in this area, Senator Shelby, have greatly reduced unnecessary regulatory burden on financial institutions regardless of their charter. The industry’s

record earnings levels suggest that whatever regulatory burdens remain, they are

not interfering with banks’ ability to do business profitably.

Dual Banking System and History of Preemption

The dual banking system is part of our democratic heritage. The phrase ‘‘dual

banking’’ refers not only to the parallel systems of State and Federal banking regulation, but also to the interaction of State and Federal laws for the benefit of our

national and local economies. Since the creation of our dual banking system in 1864,

all banks, regardless of their charter, have been subject to a combination of Federal

and State laws. The balance of State and Federal authority has evolved, shaped by

new State and Federal statutes and by a growing body of case law.

The 10 years since the passage of Riegle-Neal have transformed the financial

services industry, and in this transformation we have seen the value and strength

of our dual banking system. Many believed that nationwide banking would mean

the end of the State regulatory system—that the States would become irrelevant or

be unwilling to compromise in order to supervise multi-State institutions. Instead,

the State banking system is now stronger, in many ways, than it was 10 years ago.

Interstate branching and financial modernization have compelled all of us at the

State level to answer the hardest questions: What is the purpose of State supervision? What do we need to do to protect our citizens, and what have we been doing

just because ‘‘we always did it that way’’? How can we leverage the resources of

other agencies to improve our own performance and reduce regulatory burden?

What authority do we truly need, and what is just a battle over turf?

Senators, these are issues that all regulators struggle with daily. Because so

many powers originated at the State level, because the States were the first to pass

interstate branching laws, and because Congress let the States control the phasein to interstate branching, we have developed models for interagency information

sharing, cooperation, and coordination that benefit the entire financial services industry.

Many, even most, of the new Federal powers under Riegle-Neal and GrammLeach-Bliley originated at the State level. Over the past 10 years, however, we have

seen a new aspect of the dual banking system’s value. As new products and services

have emerged, so too have new opportunities for consumer confusion and, in some

cases, abuse. The explosion of the mortgage industry created a new class of lenders

for nonprime borrowers, and in some cases, these lenders engaged in predatory and

fraudulent practices. Many States sought remedies through enforcement of existing

State laws, new legislation, and financial education campaigns. Our efforts have

reached thousands of borrowers and potential borrowers, punished and discouraged

predatory lenders, and brought a national spotlight to this problem.

Our experience in this area shows that the dual banking system is not a museum

artifact, but a vital and essential dynamic for promoting new financial services

while offering new approaches for consumer protection.

Ten years after the passage of nationwide banking, the dual banking system is

more important than ever. It ensures diversity in our financial services system, and

it ensures that the regulatory system addresses local concerns as well as national

concerns. In this case, that specifically means the interests of local borrowers and

consumers.

The traditional dynamic of the dual banking system has been that the States experiment with new products and services that Congress later enacts on a nationwide

basis. We generally discuss this history in terms of expanded powers, but the States

have been innovators in the area of consumer protection, as well. States enacted

CRA and fair lending statutes before the Federal Government did, and States are

now leading the way on predatory lending, identity theft, regulation of overdraft

protection products, and privacy initiatives. These State laws, which the OCC sees

as burdensome to national banks, are in fact providing all of us the opportunity to

see what works and what does not, and find the appropriate balance before seeking

legislation on a national level.

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Conclusion

Our highly diverse financial system is the envy of the world. American markets

are flexible and responsive, and American banks are competitive globally as well as

locally, in large part because of our decentralized regulatory system.

We believe that our dual banking system acknowledges the needs of multi-State

banks and financial services firms while protecting consumers. We have worked

hard, within the State system and with our counterparts at the Federal banking

agencies, to develop a system of supervision that allows for innovation while ensuring safety, soundness and economic stability. The strong condition of our 6,400

State-chartered banks and 400 State-regulated offices of foreign banks is the best

evidence of our success.

CSBS looks forward to working with the Congress to find additional ways to address the needs of an evolving nationwide financial services system in a way that

maintains this strong condition, minimizes unnecessary regulatory burden, and ensures that all Americans retain their access to the broadest possible range of financial opportunity.

We thank you for this opportunity to testify, and look forward to any questions

you and the Members of the Committee might have.

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RESPONSE TO A WRITTEN QUESTION OF SENATOR SANTORUM

FROM ALAN GREENSPAN

Q.1. Chairman Greenspan, in the summer of 2002, I expressed concern with the potentially adverse competitive impact that the operational risk-based capital charge in the Basel Capital Accord will

have on U.S. banks. Last fall, the leadership of the House Financial Services Committee also raised concerns with the charge for

operational risk. What steps are being taken to ensure that these

concerns, as well as other concerns raised by Members of Congress,

are getting the attention this issue warrants? Can we expect to see

any of these concerns addressed in the next version of the Accord?

A.1. The Federal Reserve Board and other Federal banking agencies take very seriously the concern about potential competitive effects the operational risk-based capital charge in Basel II will have

on U.S. banks. Accordingly, the agencies have several initiatives

underway to address this issue.

The agencies are currently performing extensive reviews of the

large U.S. banks’ own internal assessment of the operational risks

they face and the capital that they estimate would be needed to

support those risks, using the proposed Advanced Management Approach (AMA). This benchmarking exercise will help U.S. supervisors better understand the preparedness of these banks to employ

the AMA for estimating their operational risk capital charge. The

three reviews performed to date indicate strong bank management

support for the flexible implementation of internal processes and

data collection efforts consistent with the AMA for operational risk.

In addition to the extensive benchmarking exercise, staff from

the banking agencies continue to evaluate the comments received

on the Advanced Notice of Proposed Rulemaking and through subsequent discussions with banks’ management. Based on the revised

capital framework that the Basel Committee is planning to release

in June, the agencies plan to perform a comprehensive quantitative

impact study of all the components of Basel II capital charges for

the large U.S. banks. The resulting analysis of this information

should be useful in understanding the implications of the new

framework on the overall capital requirements of banks as well as

the competitive impact. This analysis may also lead to recalibration

and revisions to the framework that would serve as the basis for

a Notice of Proposed Rulemaking in 2005.

In light of the concerns regarding potential competitive effects

that an operational risk-based capital charge may have on U.S.

banks, the Federal Reserve is also in the process of conducting an

empirical study of such possible effects. The study will specifically

address the potential competitive disadvantage that an explicit pillar one operational risk capital charge might create for U.S. banks

vis-a ́-vis nonbank competitors, non-Basel II, U.S. banks, and foreign banks whose regulators allegedly might be less aggressive in

applying Basel rules than the U.S. regulators. The results of this

study should be available by the end of the year.

In response to your final question on whether competitive concerns will be addressed in the next version of the Accord, the U.S.

regulators note that the AMA has been included in the framework

at the insistence of U.S. banks. In effect, the capital requirement

for operational risk under the AMA would be based upon the

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banks’ own internal economic capital estimate for such risk, as long

as their processes are comprehensive and well-reasoned.

RESPONSE TO WRITTTEN QUESTIONS OF SENATOR SCHUMER

FROM JOHN D. HAWKE, JR.

Q.1. Did any of the 16 Saudis who were in the United States under

diplomatic cover, but in actuality worked in a Virginia school that

was teaching terrorism, or a Saudi consular official in Los Angeles

who was deported in 2003, have accounts at Riggs or receive money

from these accounts and, if so, how much?

A.1. Riggs has conducted a search of its account records and has

identified a total of 17 accounts in the names of 11 of the 16 Saudis

that you reference. Five of these accounts have been closed leaving

12 open accounts in the names of 9 of the 16 Saudis that you reference. The Virginia school that you reference had five accounts at

Riggs that have recently all been closed. The Saudi consular official

in Los Angeles did not have an account at Riggs. Riggs is conducting a review of transaction activity for each of the accounts

identified, subject to the OCC’s oversight. The OCC is in process

of reviewing Riggs’ actions relating to these accounts and determining whether their conclusions were adequate and consistent

with the OCC’s enforcement actions.

Q.2. In your enforcement action on July 16, 2003, Riggs Bank was

tasked with filing suspicious activity reports within 150 days in relationship to these accounts. Have these reports been filed? If so,

how many?

A.2. I am precluded by law from disclosing the content or even the

existence of a SAR. However, I can tell you that pursuant to the

July 2003 cease and desist order, Riggs hired KPMG to conduct a

study of its Saudi Embassy accounts and, as part of that study,

identify transactions that were suspicious in nature and which required SAR filings.

Q.3. What are you doing to tighten things up so that there are no

future Riggs Bank situations?

A.3. We have taken and we are in the process of taking a number

of actions to improve our supervision in the anti-money laundering

area. These include supplemental directions to our examiners and

implementation of new systems that will enable us to enhance

identification of high-risk banks, and flag situations that warrant

follow-up supervisory or enforcement actions. I have described

these steps in more detail in my written testimony that was provided to the Committee for the June 3 hearing. A copy is enclosed.

Q.4. It is my understanding that there were two checks on Riggs

in relation to Bank Secrecy, one in 2000 and one in 2003, and that

most of the bad stuff occurred between. Is it that you are understaffed? If I am right about this, would you say that would not

have been enough?

A.4. Riggs has been under a great deal of scrutiny for several

years. In fact, between 2000 and 2003, the OCC conducted nine examinations and reviews that were BSA-related. More information

about these examinations and the history of our supervision of

Riggs is set forth in more detail in my written testimony that was

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provided to the Committee for the June 3 hearing. Neither the

number nor the scope of the examinations that we performed at

Riggs during the period in question was driven by staffing issues.

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1 An industrial bank can be owned by a bank holding company, in which case the parent company is subject to Federal Reserve supervision. Under a proposed rule, broker-dealers that own

ILC’s may soon be able to choose consolidated supervision by the Securities and Exchange Commission. See Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities, 62 Fed. Reg. 62872 (proposed November 6, 2003, to be codified at

17 CFR Part 240).

RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT

FROM DONALD E. POWELL

Q.1. Concerns have been raised about the fact that the owners of

industrial loan banks are not regulated as bank holding companies

by the Federal Reserve. Some critics have charged that industrial

banks, their depositors, and perhaps the deposit insurance system

are endangered by the banks’ affiliation with ‘‘unregulated’’ parent

companies.

Q.1.a. Can you describe the regulatory regime that applies to industrial loan banks and their parent companies? What authority do

the FDIC and State bank regulators have to look into the activities

of industrial banks’ holding companies and affiliates?

A.1.a. The FDIC and State bank supervisors regulate industrial

loan companies and industrial banks in the same manner as other

State nonmember banks. Industrial banks are subject to the

FDIC’s safety and soundness regulations (with the exceptions discussed below), as well as Federal consumer protection regulations.

The FDIC’s authority to pursue formal or informal enforcement actions against an industrial bank is the same as the FDIC’s authority with respect to any other State nonmember bank, with limited

exceptions pertaining to cross-guaranty and golden parachute payments (although legislative corrections are being pursued in the

proposed Financial Services Regulatory Relief Act of 2003).

Like all insured depository institutions, industrial banks receive

regular examinations, during which compliance with regulations is

reviewed and overall performance and condition are analyzed. For

FDIC-insured, State-chartered banks that are not members of the

Federal Reserve System, the FDIC, or the State authority conducts

the examination. The FDIC has agreements with most States to

conduct examinations under alternating schedules, although in the

case of larger or troubled institutions, the FDIC and the State authority generally conduct joint or concurrent examinations.

Aside from the differences noted above for which legislative corrections are being pursued, the FDIC’s authority over insured industrial banks is essentially the same as its authority over other

State nonmember banks, and is considered adequate to protect the

deposit insurance funds.

Although companies that control industrial banks are generally

not regulated by any Federal banking agency,1 the FDIC and chartering State authorities directly supervise an insured institution’s

activities and other relationships with the parent company. An industrial bank must comply with Sections 23A and 23B of the Federal Reserve Act, which restrict or limit transactions with a bank’s

affiliates—including parent companies—and with established Rules

and Regulations, including:

• Part 325 pertaining to capital standards,

• Part 364, which requires safe and sound standards of operation,

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• Regulation 0, governing credit to insiders and their related interests, and

• Consumer protection and CRA regulations.

As with all insured depository institutions, if an industrial bank

becomes undercapitalized, its parent company must guarantee that

the bank will comply with the capital restoration plan that the

bank must submit under the Prompt Corrective Action provisions

of the Federal Deposit Insurance Act. An industrial bank’s parent

company, however, is not subject to the penalties imposed on a financial holding company if a subsidiary bank has an impairment

of capital or receives a less than satisfactory CRA rating. The industrial bank itself would be subject to standard administrative actions to resolve a capital impairment issue or a less than satisfactory CRA rating. The parent company of an industrial bank would

not be subject to forced divestiture or legal restrictions that may

be imposed on financial holding companies with such problems at

the bank level.

In examining any insured depository institution, the FDIC has

the authority (under 12 U.S.C. § 1820(b)(4)) to examine any affiliate

of the institution, including its parent company, as may be necessary to determine the relationship between the institution and

the affiliate and to determine the effect of such relationship on the

institution. Consequently, the FDIC has the authority to examine

the parent company of an industrial bank for the purposes of determining (i) the relationship between the industrial bank and its

parent and (ii) the effect of such relationship on the industrial

bank. In the case of a parent company that is subject to the reporting requirements of another regulatory body covered under the

Gramm-Leach-Bliley Act of 1999, such as a State insurance commissioner, the FDIC has agreements in place to share information

with the functional regulator.

The vast majority of industrial bank parent companies are subject to the examination authority of their respective State supervisor. The States of Utah, California, and Nevada, which collectively supervise 47 of the 55 FDIC-insured industrial banks, have

direct authority to conduct examinations of parents and affiliates.

The Utah Department of Financial Institutions (DFI) requires all

parent companies to register with the State under Section 7–8–16

of the Utah Code, and has authority to examine such companies

under Section 7–1–510. California law no longer makes a distinction between banks and industrial loan banks; currently both entities are subject to the California State Financial Code. The

California DFI has authority to examine parent organizations

though Chapter 21, Section 3700 (specifically Section 3704) of the

California Financial Code and to require reports and information

through Section 3703 of the California Financial Code. In the State

of Nevada, holding companies are required to register with the Secretary of State. The Financial Institutions Department for the

State of Nevada has authority to conduct examinations of parent

organizations in Section 658.185.

Q.1.b. Does the FDIC use its authority to examine industrial

banks’ parent companies? What is the nature of this review? What

has been the agency’s experience?

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A.1.b. As noted earlier, the FDIC has the authority to examine an

industrial bank’s parent for the purpose of determining (i) the relationship between the industrial bank and its parent and (ii) the effect of such relationship on the industrial bank. When it has been

deemed necessary to review such relationships, the existence of

this examination authority has greatly enhanced the FDIC’s success in obtaining the information needed to make such determinations without any resistance from the parent organization. As a

result, the FDIC has had only two cases where it had to use its

authority to examine industrial banks’ parent companies on-site.

These cases were problem situations that involved securitization

activities run through the parent organization.

It is important to note that industrial banks that have been

rated 3, 4, or 5 had problems that are not unique to their charter,

nor have troubled industrial banks had a history of unusual influence from parent companies or affiliates. The issues facing the

troubled institutions have not been dissimilar from those encountered by the industry at-large, including those in a traditional bank

holding company framework.

Q.1.c. Does the relationship of an industrial loan bank to its holding company involve risks that are not present with regard to commercial banks and bank holding companies? If so, what does the

FDIC do to address them?

A.1.c. Most existing industrial banks are generally operating under

a business model that is not dissimilar to those of commercial

banks and bank holding companies. These models can be grouped

into the following broad areas:

• Institutions serving a community niche—these institutions often

provide credit to consumers and small- to medium-sized businesses. In addition to retail deposits, funding sources may include commercial and wholesale deposits, as well as borrowings.

Institutions that operate within a larger corporate organization

also may obtain funding through the parent organization.

• Institutions that focus on specialty lending programs, including

leasing and factoring-funding sources for this relatively small

number of institutions may include retail and commercial deposits, wholesale deposits, and borrowings.

• Institutions that are embedded in organizations whose activities

are predominantly financial in nature, or within the financial

services units of larger corporate organizations—these institutions may serve a particular lending, funding, or processing

function within the organization. A few institutions restrict

themselves to facilitating corporate access to the payment system

or supporting cash management functions, such as administering

escrowed funds.

However, a few industrial banks do operate under a business

model that does involve activities that directly support the parent

organizations’ distinctly commercial activities. These institutions

largely finance retail purchases of parent company products, ranging from general merchandise to automobiles, fuel for rental car operations, and heating and air conditioning installations. Loan products might include credit cards, lines of credit, and term loans.

Funding is generally limited to wholesale or money center operVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00120 Fmt 6633 Sfmt 6601 24910.TXT SBANK4 PsN: SBANK4
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ations, borrowings, or other options from within the parent organization. The FDIC ensures that these risks are addressed by the

bank’s risk management practices through the examination process

and regulatory controls over affiliate transactions, requirements for

safe and sound operations, minimum capital standards, and the

other supervisory and regulatory authority described earlier.

Q.2. Concerns have also been raised about whether liberalized

interstate branching authority, if approved by Congress for commercial banks, should also apply to industrial loan banks.

Q.2.a. Isn’t it true that industrial loan banks currently have the

same branching authority (and the same branching limitations) as

other banks? To what extent have they used this authority in the

past? Is any industrial loan bank operating a network of bank

branches in the States where they are permitted to do so?

A.2.a. Industrial banks, like other State banks, get their power to

branch from their chartering authority. Generally, industrial banks

have the same branching authority (and are subject to the same

branching limitations) as other State banks. Currently, the majority operate in Utah and California, which provide essentially the

same branching authority to industrial banks as to other State

banks. This authority has not been used to any significant extent.

There are a few industrial banks with a relatively small network

of branches (2,030 branches); however, these branches provide limited services (such as purchasing auto loans from local auto dealers) and do not operate as typical commercial bank offices. As of

year-end 2003, industrial banks were either: (i) community focused

with few, if any, branches; (ii) focused on specialty lending programs, such as credit cards, leasing, or factoring; or (iii) embedded

in organizations whose activities are predominately financial in nature.

All the largest industrial banks are subsidiaries of large financial

firms (such as Merrill Lynch) and serve a specific lending, funding,

or processing function within the organization. These entities tend

to have very limited branching or none at all. For example, Merrill

Lynch Bank USA has two branches. American Express Centurion

Bank, UBS Bank USA, BMW Bank of North America, Volkswagen

Bank USA, and Volvo Commercial Credit Corp of Utah have no

branches.

Q.2.b. Has branching by industrial loan banks been harmful has

there been injury to depositors, competitors, or the deposit insurance system?

A.2.b. Since branching by industrial banks has been limited, there

are no identified problems in this area that have been harmful to

depositors, competitors, or the deposit insurance system. While

branching by industrial banks is limited, some industrial banks

still engage in activities that are statewide, regional, or national in

scope. However, these serve a narrow customer niche. This group

of industrial banks has had few problems during their existence.

Likewise, branching activity by this group has not been harmful to

depositors, competitors, or the deposit insurance funds.

Q.2.c. If industrial loan banks, along with other banks, were given

expanded de novo branching authority, would the FDIC and State

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regulators have the power to prevent abuses of this authority?

Would this authority give industrial loan banks a competitive advantage over other banks or over bank holding companies? If it

would create inequalities, could the FDIC do anything to address

them?

A.2.c. The FDIC’s ability to deal with potential abuses arising from

expanded de novo branching authority for industrial banks would

be the same as for any other State nonmember bank. Any branching activities by an industrial bank would be subject to the same

application and approval process with the FDIC and State authorities as any other state nonmember bank. The FDIC and State bank

supervisors regulate industrial banks in the same manner as other

State nonmember banks. Industrial banks are subject to the

FDIC’s safety and soundness regulations (with the three exceptions

discussed in the answer to question 1.a., above), as well as Federal

consumer protection regulations. The FDIC’s authority to pursue

formal or informal enforcement actions against an industrial bank

is the same as the FDIC’s authority with respect to any other State

nonmember bank.

Q.3. What would be the impact of legislation allowing industrial

loan banks to pay interest to corporate owners of NOW accounts

(which did not repeal the current prohibition against offering

checking accounts)?

A.3. If legislation is passed to allow industrial loan banks to pay

interest on corporate NOW accounts, we would anticipate that

some would offer these accounts. Currently, some industrial banks

can and do offer demand deposits, and it is likely that if allowed

to do so, some would offer corporate NOW accounts. The issue is

one of competitive concern rather than one of regulatory concern.

If legislation is passed that allows only commercial banks to offer

interest-bearing demand deposits to their corporate customers, but

does not repeal the current prohibition on industrial banks from offering NOW accounts to corporate customers, it would create disparity in the treatment of industrial banks and commercial banks.

Currently, small industrial banks (those under $100 million) and

those grandfathered under the Competitive Equality Banking Act

of 1987 (CEBA) may offer demand deposits. Such legislation would

exclude them from being able to compete with commercial banks as

they currently may do.

Q.3.a. Does the business model of industrial loan banks suggest

that providing corporate NOW accounts is now, or would become,

widespread? If so, does this raise regulatory concerns, and does the

FDIC have the ability to address them?

A.3.a. The business model of most industrial banks precludes them

from providing corporate NOW accounts because NOW accounts

are only available to individuals, certain nonprofit organizations,

and governmental units. Further, most industrial banks cannot

offer demand deposits, either because their size precludes them

from doing so or they were not grandfathered under CEBA.

As one would predict from the restrictions cited above, the data

on industrial loan companies show that few fund themselves

through either demand deposits or NOW accounts. As of year-end

2003, only 4 of 52 industrial banks funded more than 10 percent

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of their assets through noninterest bearing deposits. Another 11

funded between 1 percent and 10 percent of their assets with noninterest bearing deposits. The vast majority of industrial banks did

not rely on these deposits as a source of funding.

The group of industrial banks offering NOW accounts was even

more constricted. Only 14 industrial banks showed any NOW account activity. Of these, 8 funded more than 1 percent of their

asset base with NOW accounts, and no institution funded more

than 5 percent of assets with these accounts.

Whether a change in the legislation would lead industrial banks

to offer NOW accounts to corporate customers is unknown, as their

current business models would not be focused on this as a source

of funding.

Q.3.b. Would the offering of interest bearing NOW accounts to corporations raise regulatory concerns? If so, does the FDIC have the

authority to address them?

A.3.b. As mentioned above, allowing industrial banks to provide

corporate NOW accounts is an issue of competitive concern rather

than one of regulatory concern. As with thrifts in the late 1970’s

and early 1980’s, the ability to provide products that are similar to

checking accounts brings new competition into the banking sector.

Moreover, eliminating the prohibition would lead to greater economic efficiency for both banks and industrial banks as they would

be able to charge explicitly for services they now provide for free

or at a discount. The time and expense associated with transactions designed to circumvent the prohibition, such as interestrate sweep accounts, would be reduced or eliminated.

The FDIC does not anticipate that there would be any safety and

soundness issues posed by the payment of interest on NOW accounts held by businesses. Extending the ability to pay interest on

corporate NOW accounts will not pose a threat to the stability of

the financial system. The FDIC currently supervises industrial

banks and State-chartered, nonmember banks that offer NOW accounts. There should be no particular concern with these accounts

beyond the normal supervisory concerns of requiring institutions to

know their customers and manage the accounts in a safe-andsound manner.

Q.4. Concerns have been raised about Wal-Mart acquiring a bank

charter. Last summer, the FDIC conducted a symposium on banking and commerce to explore this issue.

Q.4.a. Is Wal-Mart an applicant for an industrial loan bank charter

or any other bank charter?

A.4.a. We are not aware of any pending charter application by WalMart. Neither Wal-Mart Stores, Inc., Bentonville, Arkansas, nor

any of its subsidiaries, have filed an application or notice with the

FDIC.

Q.4.b. Would the FDIC be involved in the process of approving

such an application?

A.4.b. The FDIC would be involved in approving deposit insurance

for any newly chartered bank. Although an application for a charter and for deposit insurance may be filed under a single interVerDate 11-MAY-2000 17:54 Dec 13, 2005 Jkt 000000 PO 00000 Frm 00123 Fmt 6633 Sfmt 6601 24910.TXT SBANK4 PsN: SBANK4
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agency application, the FDIC retains full authority with regard to

deposit insurance determinations.

If a retail company sought to acquire control of any existing

State, nonmember bank, under Section 7(j) of the FDI Act, 12

U.S.C. § 1817(j), it would have to provide the FDIC written notice

of that transaction. The FDIC would review and have authority to

disapprove the proposed acquisition within the notice period provided under the law based on several statutory factors.

Q.4.c. Do the FDIC and State regulators have the authority to impose conditions on the approval of such an application (for example,

limitation on the bank’s activities or its branching authority)?

A.4.c. In approving deposit insurance, the FDIC has the authority

to, and generally does, impose conditions on the approval. The

FDIC’s ‘‘standard’’ conditions, among other more routine requirements, require final approvals from other appropriate regulatory

agencies and reserve authority for the FDIC to alter, suspend, or

withdraw approval before consummation should any interim development be deemed to warrant such action.

The FDIC also may impose restrictions or prudential conditions

in addition to standard conditions. Examples of such safeguards include requiring adequate capital and liquidity, a business plan appropriate to the nature and complexity of activities conducted by

the bank, on-site management, an independent board of directors,

and policies and controls to ensure arm’s-length transactions with

the parent and other affiliates. In regard to branch authority specifically, the FDIC normally relies on the broad statutory framework governing branching activities embodied in Section 18(d) of

the FDI Act, 12 U.S.C. § 1828(d).

The specific conditions imposed generally depend on the purpose

and placement of the institution within the overall organizational

structure and reflect the statutory factors of Section 6 of the FDI

Act, 12 U.S.C. § 1816, that must be considered in reviewing all applications for deposit insurance. These factors are:

• The financial history and condition of the depository institution;

• The adequacy of its capital structure;

• Its future earnings prospects;

• The general character and fitness of its management;

• The risk presented by such depository institution to the deposit

insurance fund;

• The convenience and needs of the community to be served by the

depository institution; and

• Whether its corporate powers are consistent with the purposes of

the FDI Act.

The FDIC supports provisions in the Financial Services Regulatory Relief Act of 2003 that would clarify its existing authority

to approve or disapprove a change in control notice. Specifically,

Section 405 of the bill clarifies the Federal banking agencies’ authority under Section 8 of the FDI Act, to enforce written conditions in connection with, among other things, any notice concerning

a depository institution. Section 409 clarifies the FDIC’s authority

to consider the risks inherent in a proposed business plan and to

use that information in determining whether to disapprove a notice

of change in control.

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Q.4.d. What has the FDIC learned from its experience with other

retailers who have owned banks in the past, such as Sears, Montgomery Ward, and JC Penny? What type of banking services did

these banks provide? Did their relationship with their holding companies endanger consumers, communities, competitors, or the deposit insurance system?

A.4.d. Generally, our experience indicates that insured institutions

owned by retail companies can be satisfactorily served by their relationships with their parent organizations, both financially and

otherwise. Benefits include access to capital and liquidity, operational support and expertise, and an established pool of potential

customers. Overall, these benefits flow to the communities in which

the organization operates in the form of expanded financial options

for both deposit and loan products. However, in our experience,

these benefits have not proved so great that competitors—either

banking or retail—have been endangered. Overall, our experience

is that such relationships generally serve as a source of strength

to the insured institution and the deposit insurance fund.

The universe of insured institutions currently includes, as it has

in the past, institutions controlled by retail organizations. These

banking subsidiaries conduct traditional banking activities, generally operate from a single location, and market products and

services through the parents’ locations or operations. Receivables,

predominantly credit card balances, are generally held by the institution or periodically sold to the parent organization. Deposits are

comprised of parent company accounts, certificates of deposit solicited from the parent’s customers, and/or funds acquired through

the national markets.

Q.4.e. What regulatory concerns would arise if a retailer were to

acquire an industrial loan bank? Is the FDIC empowered to address these?

A.4.e. The risk posed by any insured depository institution, whether owned by a retailer or otherwise, is a factor of the appropriateness of the business plan and model, management’s competency in

administering the institution’s affairs, and the quality and implementation of risk management programs. Commercial firms have

been allowed for many years to operate, or to acquire and control,

existing or newly formed financial institutions exempted from the

Bank Holding Company Act (BHCA). This exemption applies to institutions chartered as industrial loan companies as well as certain

institutions covered by the Competitive Equality Banking Act

(CEBA). Congress, in passing the Gramm-Leach-Bliley Act, lifted

certain restrictions on the affiliations of banks and financial-services firms, and left in place the existing exemptions from the BHCA

applicable to both industrial banks and CEBA institutions.

Control of an institution by a retailer does raise the questions

surrounding the mixing of banking and commerce. The FDIC believes that if adequate safeguards are in place, there is no compelling safety and soundness reason to preclude retailers from owning

an industrial bank. To ensure safe and sound operations that protect the interests of industrial banks, their depositors, and the insurance fund, examinations necessarily involve a more complex

analysis to ensure that the institution is especially diligent to:

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• inform its customers of products that are not FDIC-insured; • maintain physical separation in offering insured and uninsured

financial products; establish policies against prohibited tying arrangements; and • comply with the restrictions limiting transactions between banks

and their affiliates.

As with any other insured institution, existing and newly insured

industrial banks are subject to on-site examinations and other supervisory activities of the FDIC as well as the appropriate State

chartering authority. Even if the institution is controlled by a commercial enterprise, a well-developed supervisory strategy can effectively insulate an insured institution from potential abuses and

conflicts of interest.

The FDIC’s regulatory regime and supervisory authorities that

apply to industrial banks and their parent companies are described

in the answers to question 1.